During the years from 2009 to 2016, when interest rates were very low, both master limited partnerships and real estate investment trusts served as sources of capital appreciation and income.
But with rates rising, performance is diverging for the two asset classes, and MLPs are outperforming.
“Evidence suggests that when rates are rising, MLPs do better and REITs do worse,” says Jack Ablin, founding partner and chief investment officer of Cresset Wealth Advisors in Chicago.
The Vanguard Real Estate ETF (VNQ), which can be used as a proxy for REITs, has a positive 0.51 correlation with the Bloomberg Barclays Aggregate U.S. Bond Index over the past three years, according to FactSet data provided by Michael Sheldon, executive director and chief investment officer at RDM Financial Group-Hightower.
That means when bond prices fall, REITs are likely to do the same.
But when it comes to MLPs, the Alerian MLP exchange-traded fund (AMLP) has a negative 0.08 correlation with the same Bloomberg U.S. Bond Index over the past three years. That means that when bond prices fall, MLPs have a good chance to rise.
So, why are rising rates bad for REITs but good for MLPs?
When it comes to REITs, they are highly dependent on borrowing to finance real estate purchases. So, higher rates mean higher borrowing costs.
REITs also compete with other investments based on income payouts, and higher rates mean higher yields for bonds and other income assets.
“REITs have a double whammy there,” Ablin says.
They are also overvalued in general, trading above the 75th percentile of their historical range in terms of price-to-funds from operations, he says.
Meanwhile, most MLPs are oil and gas pipelines, which have long-term fee-based contracts, with rent escalators built in, Sheldon says.
They are also benefiting from the buildout of the nation’s energy infrastructure.
In addition, MLPs have stronger balance sheets than REITs, Sheldon says.
As of Dec. 31, leverage (net debt-to-earnings before interest, taxes, depreciation and amortization) stood at 5.9 for REITs, as measured by the Vanguard Real Estate ETF, and 5.5 for the Alerian MLP ETF.
Moreover, MLPs carry a yield advantage.
The Alerian MLP ETF was yielding 8.3% as of May 18, compared with 4.8% for the Vanguard Real Estate ETF.
“Even if interest rates continue to move higher, MLPs offer a yield cushion that could help insulate investors,” Sheldon says.
So, MLPs are more attractive now than REITs, observers say.
“MLPs offer valuable diversification to an income portfolio,” Ablin says. “They zig when others zag.”
This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.