MLPs: A Potential Longer-Term Shelter During Rising Rates
With strengthening data on the economy and labor market, investor anxiety has begun to intensify over the potential impact rising rates may have on the equity markets. In fact, the Dow Jones Industrial Average experienced a 4.6% drop on February 5, the worst one-day performance since August 2011, an apparent reaction to a bump in Treasury yields. Whenever the market appears to be potentially entering a rising interest rate environment, investors often seek to understand how the midstream sector has historically performed over such periods.

As discussed below, over long-term periods, midstream energy equities—specifically master limited partnerships (MLPs)—have not demonstrated meaningful correlation to interest rate changes. However, short-term periods of weakness have occurred in response to dramatic moves in the interest rate.

Over the past decade, there have been four periods over which interest rates rallied by at least 100 basis points:

  • In the wake of the 2008 financial crisis, the yield on the 10-Year U.S Treasury increased by 189 basis points. Over this period, MLP equities, as measured by the AMZ Index, appreciated 33%, while utilities, as measured by the Dow Jones Utilities Index, and real estate investment trusts (REITs), as measured by the Dow Jones Equity All REIT Index, declined 5% and 6%, respectively. Utilities and REITs are often cited as yielding equity-sector comparisons.
  • From late 2010 to February 2011, the 10-year yield increased by 135 basis points. Over this period, the AMZ Index appreciated 7% while utilities and REITs increased by 3% and 8%, respectively.
  • From June 2012 to September 2013, the 10-year yield increased by 154 basis points. Over this period, the AMZ Index appreciated 22% while utilities and REITs increased by 1% and 7%, respectively.
  • From July 2016 through mid-December 2016, the 10-year yield increased by 136 basis points. Over this period, the AMZ Index declined by 4% while utilities and REITs declined by 10% each.

The current period of interest rate pressure appears to have begun in September 2017 and, through the end of February, the 10-year yield has risen 82 basis points. Over this period, the AMZ Index has declined 8% while utilities and REITs have declined 10% and 11%, respectively (Exhibit 1).

Whether this latest move in interest rates will soon exceed 100 basis points or moderates is uncertain, though history reveals that MLP price performance over these periods is not necessarily dictated by a rate change.

The correlation statistic of MLP price performance to changes in the 10-Year Treasury yield over these periods also suggests that the interplay between rate changes and the midstream sector is fairly weak or fleeting. In fact, over several of these periods, the correlation between MLPs and yields has been moderately positive, with MLP equities actually moving higher as the 10-year rate increased. Interestingly, utilities and REITs demonstrated greater negative correlation to rising interest rates over these periods, meaning that both subsectors demonstrated a greater propensity to trade lower on rising rates (Exhibit 2).

As noted above, short-term periods of weakness in midstream energy equities have occurred in response to dramatic interest rate moves. Of course, over such periods, the broader equity markets, as well as REITs and utilities, have often reflected trading weakness. However, over time, MLP equities have exhibited little sustained impact from interest rate changes, as the data above demonstrates. In fact, since 1996 (the earliest available data on the AMZ Index), the monthly correlation of MLPs to the 10-Year Treasury has been only 0.21.

We believe the low correlation cited above suggest that, over time, underlying business fundamentals are a significantly greater driver of investor interest than is the interest rate environment. In other words, it appears that over these historical periods of rising rates and the resulting increase in returns offered by alternative fixed-income securities, the perceived total return potential on MLPs has generally remained good enough that few investors have chosen to sell MLPs and purchase other assets.

Of course, just as in every typical market commentary, we caution investors not to rely on historical results to predict future performance. However, we do believe that the midstream sector is well positioned for a rising rate environment, as our outlook for the U.S. energy sector is stable. Additionally, we believe that U.S. production growth will continue to increase moderately while midstream equity valuations remain at historically attractive levels.