In the aftermath of the financial crisis debt became a four-year word for some, and six years later it still sounds like a dangerous burden to many.
That's understandable, given the dire consequences of all the debt that couldn't be repaid.
Never mind that without debt and borrowers there would be no returns for savers, nor many schools, roads, airports and other projects, public and private, that are typically financed in the bond markets.
The midstream energy sector is one of the few within the corporate economy that has dramatically increased its investment over the last decade, instead of shrinking it in order to return more capital to shareholders.
The capital spending required to accommodate the U.S. shale oil and gas production boom has been huge, and will need to remain so for many years.
U.S. Energy Infrastructure Investment Forecast
Source: IHS
This has meant that, far from returning capital, the master limited partnerships that dominate the midstream sector have had to raise lots of it from limited partners and bond buyers.
And given debt's fearsome reputation, that's given critics of MLPs an opening to claim that they're using it to disguise their true financial state and overstate their staying power.
Those claims are based on a kernel of truth. It is, in fact, possible to use a debt-fueled acquisition spree to make an unsustainable business model look sustainable for a while. It's also possible to use borrowing and equity issuance to pay a distribution not reflective of business fundamentals, or to finance maintenance spending with debt, mislabeling it as growth capital.
Debt makes all of these fudges feasible, just as it makes feasible the construction of an oil pipeline or natural gas processing plants.
That's whyMLP Profitsclosely follows such leverage metrics as debt-to-EBITDA and changes in debt levels to make sure that our recommendations are not living on borrowed time.
But we also understand that debt is an essential ingredient in this period of rapid midstream growth. MLPs are pursuing lucrative projects backed by fixed-fee, long-term contracts with big energy producers. Their willingness to take on low-cost debt to pull these off can hardly be held against them.
In fact, failing to do so these days often means foregoing the cheapest capital. Let's use the example of Targa Resource Partners (NYSE: NGLS), the fast-growing midstream gatherer and processor.
Last month Targa sold $800 million in unsecured senior five-year notes at a yield of 4.125%, which management proudly notes is one of the lowest yields this year for a callable bond rated below investment grade.
And because interest paid on debt is tax-deductible, Targa's interest payments reduce its limited partners' income taxes in the long run. (In the short run, of course, most MLP distributions are mostly tax-deferred.)
Now let's look at the cost to NGLS to finance a project with equity instead of debt. Its units currently yield 5.4%, and on that basis alone the cost of equity financing is higher by more than a full percentage point, or 30%.
But for every extra cent per unit above current levels paid out to limited partners, NGLS will owe another cent in what's known as incentive distribution rights to its general partner, Targa Resources (NYSE: TRGP). That puts its effective cost of equity capital at 10.8%, more than two-and-a-half times higher than the cost of debt. And, unlike interest paid, increased incentive payments to the general partner are not tax deductible.
The bottom line is that limited partners, especially those investing in MLPs that owe incentive distribution rights, should be grateful for every dollar borrowed rather than raised in an equity offering, at least in the current low interest rate environment.
Leverage ratios at some MLPs remain elevated amid heavy spending, while others have already made good progress on ratcheting them down as recently completed projects start to pay off.
In fact, given the low cost of debt, it's impressive that several of our top picks at MLP Profits retain a third or more of their cash flow to reinvest. As a rule, these tend to be partnerships that are growing rapidly.
Low interest rates also help explain why MLPs continue raising distributions even while borrowing money for expansion. Tax-deferred yield has always been a big selling point for such investments, and all the more so now given a shortage of attractive alternatives.
And yet the industry needs to raise more capital than it spreads around right now to keep up with the needs of its customers.
Borrowing the money is not only the most tax-efficient response but often also the most affordable one for the limited partners.
This article originally appeared in the MLP Investing Insider column. Never miss an issue. Sign up to receive MLP Investing Insider by email.
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