Will rising interest rates hurt pipeline company stocks? Ten-year treasury yields are at 3.25%, a seven year high. The bond market is commanding the attention of equity investors once more.

The high yields on MLPs have long attracted income-seeking investors. A common valuation metric is to compare the sector’s yield with the ten year treasury by measuring the yield spread. This is currently around 4.8%, compared with the twenty year average of 3.5%. In comparison, REITs and Utilities both have yield spreads under 1%.

While the MLP yield spread is historically wide, it’s been wider than average for almost five years, which probably means that the relationship has changed. Over the past decade, it’s averaged 4.5%. MLP investors require a richer premium to other asset classes than in the past, which is why the bigger MLPs have been converting to corporations, so as to access a wider investor base (see Growth & Income? Try Pipelines).

 

While MLP yields have remained stubbornly high, they continue to move independently of the bond market. Visually, energy infrastructure and ten year treasuries have no relationship at all. The correlation of monthly returns is -0.35 over the past decade and 0.16 over the past five years – practically speaking, there is no correlation between the two.

 

Over short periods of time, fund outflows from income alternatives can depress MLP prices, but the effect is rarely enduring. Tariffs on regulated pipelines often include an inflation escalator, allowing increases pegged to the Producer Price Index (PPI), which creates some inflation protection for pipeline owners if inflation was to spike higher. This is why we often tell investors that the impact of higher rates depends on whether inflation is rising or not. If rising inflation drives up yields, the higher PPI will feed directly into higher revenues where contracts are correctly structured.

However, if rates move up independently of inflation (i.e. higher real rates), then all assets are affected. Any investment is worth the sum of its future cashflows discounted at an appropriate interest rate. Pipeline stocks would likely be affected like many other sectors.

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