NEW YORK, May 4 (Reuters) - A recent U.S. agency ruling limiting certain tax benefits for energy master limited partnerships (MLPs) dealt a blow to a security class investors had loved for their income but now look likely to steer clear of even though they look cheap.
MLPs are tax-exempt corporate structures that pay out profit to investors in dividend-style distributions, many of which are oil and natural gas pipeline companies.
The Alerian MLP index plunged 4.6 percent after the Federal Energy Regulatory Commission said in March they will no longer be allowed to recover an income tax allowance as part of the fees they charge to shippers under a "cost of service" rate structure.
A U.S. Appeals Court in 2016 ruled that energy regulators were allowing them to benefit from a "double recovery" of taxes, leading to the FERC ruling.
The index is down nearly 8 percent for the year, after a drop of almost 13 percent in 2017, as expectations of higher interest rates, depressed commodity prices and the recent ruling have combined to keep investors wary.
"The sentiment around MLPs at this point is just so negative it doesn’t matter what pops up," said John LaForge, head of Real Asset Strategy at Wells Fargo Investment Institute in Sarasota Florida.
"Maybe you would’ve expected even after the FERC decision you would get the initial reaction of the negative and then the value guys step up and say 'this is crazy,' but they didn’t do it. You don’t even have the value guys interested at this point."
High dividend yields are a hallmark of MLPs, leading many investors to use them as sources of income. While the dividend yield of the Alerian index was at 8.14 percent at the end of April, it has been on a downward slope since hitting a two-year high of 8.92 percent on March 28.
The MLP index reached a record high in September 2014, as oil prices hovered near $100 a barrel and their high dividends made them attractive to investors in a low interest rate environment.
Bond yields are rising, undermining the interest rate premium of MLPs and reducing demand, and the U.S. Federal Reserve has shown no signs of deviating from its path of tightening.
U.S. benchmark 10-year notes hit a four-year high yield just over 3 percent in April while U.S. two-year yields recently crossed the 2.5 percent mark for the first time in nearly a decade.
"For the last decade or so easy monetary policy has led a lot of money to income substitutes and bond proxies," said Michael Arone, Chief Investment Strategist at State Street Global Advisors in Boston.
"As rates have been moving up, particularly on the short end, you are seeing a lot of the kind of weak money leave pretty quickly."
Still, Jeremy Held, director of research at ALPS Portfolio Solutions in Denver, which is the issuer of the Alerian MLP ETF , notes there was a weak correlation between MLPs and interest rates over the 10-year period between 2006 and 2016.
When rates rise, "initially they sort of sell off any rate-sensitive asset class – utilities, bonds, MLPs, telecoms," said Held.
"Then when the dust settles people actually look and say it matters if you can grow your (dividend) distribution faster than rates are rising, or is there still a spread."
MLPs have shown some signs of life recently. After selling off on the FERC ruling, the Alerian index was up 3.1 percent through Thursday since March, compared with a 4.3 percent drop in the S&P 500.
Oil prices have also continued to climb, with WTI up more than 11 percent and Brent crude up more than 13 percent since the announcement. As MLPs generally track closely or above oil prices, they could be poised to regain their cachet.
"If you look at the demand numbers out there, demand is very good," said Stephen Massocca, Senior Vice President at Wedbush Securities in San Francisco. "There is some catching up to do, these things are dirt cheap."
Reporting by Chuck Mikolajczak; Editing by Alden Bentley and Susan Thomas