Pipelines, Partnerships, and Payouts: CEFs Unlock Infrastructure Income

The beauty of closed-end funds (CEFs) remains in their structure. How they are formed and traded allows them to do some pretty amazing things that other fund vehicles like mutual funds and ETFs simply can’t do. One of the biggest challenges is their ability to hold illiquid and esoteric asset classes.

And you can’t get more esoteric than infrastructure and energy master limited partnerships (MLPs).

It turns out that MLPS and CEFs were made for each other. Offering investors tax advantages, nearly double-digit yields, and steady monthly income, closed-end funds are a great way to add a dose of energy infrastructure to a portfolio.

A Quick MLP & Infrastructure Primer

These days, more and more investors are looking towards alternatives to power their portfolios, as stock and bond correlations, returns, and risks continue to be skewed. Copying many institutional, endowment, and pension investors, infrastructure has quickly become a significant component of these alternatives.

Because of its cash flow-driven returns, the asset class is seen as steady, providing 3 to 6% gains, year in and year out. Moreover, many of the cash flows driven by infrastructure tend to be inflation-protected. There are annual increases tied to using a toll road or transmission line. As such, the asset class has gone on to perform exceptionally well over its history.

A subsector of energy infrastructure remains midstream firms. These are owners of pipelines, storage facilities, processing plants, and other pieces of infrastructure that connect the producers of oil (upstream) with the end-users (downstream). Some of these midstream firms have used the master limited partnership (MLP) structure for their assets.

MLPs are an interesting piece of the tax code that allows energy firms—as well as a few other sectors—to create essentially pass-through vehicles for some of their assets. As such, as a pass-through vehicle, an MLP is exempt from corporate taxes. They simply pass through the cash to their unitholders.

CEFs & Energy Infrastructure: Match Made In Heaven

Now, there are a lot of ways that investors can get their hands on infrastructure these days. You can buy ETFs that track these firms, or you can purchase individual MLPs such as MPLX LP.

But closed-end funds may have a real advantage over all these fund structures when it comes to infrastructure and MLPs.

For starters, there is the long nature of the asset class. Unlike equities, trading of pipelines, storage facilities, power plants, and physical assets isn’t really a thing. These are very much “buy & hold” assets. The idea is to extract the cash flow from them, not flip to make a quick buck. That lends itself to the CEF structure.

Because CEFs are traded on exchanges independent of their values, managers can buy & hold these assets, and firms can really focus on their dividends/distributions. This allows investors to maximize their returns from the asset class. Mutual funds need to worry about investor redemptions and could fire-sell these illiquid assets to meet those redemptions.

Secondly, it comes down to actual structure and SEC Rules. Under the Investment Company Act of 1940, regulated investment companies (RICs)- which include mutual funds, ETFs, and CEFs- are limited to having no more than 25% of their assets in MLPs and other pass-through structures like royalty corps. However, many MLP-focused CEFs have gotten around this by being structured as C-corporations themselves. This creates a deferred tax liability (DTL). Depending on the movement and pricing of the underlying assets, these can actually reduce the corporate taxes owed by the fund and the investor’s return.

Speaking of taxes. The beauty of MLPs is that their high distributions are treated as returns of capital and reduce the cost basis of the initial investment. Investors can defer those taxes until the investment is sold. CEFs treated as a C-Corp can still pass these distributions back as a return of capital to portfolios, lowering an investor’s cost basis, deferring taxes, and eliminating the need for a K-1 statement come tax time. Investors will receive a standard 1099-DIV.

This chart from Nuveen shows that MLP CEFs have been champions in deferring taxes when looking at other CEF-heavy asset classes.

Source: Nuveen

Then there is leverage to consider. Since CEFs are allowed to use leverage to increase their returns, the already juicy yields of MLPs- in the 6% to 8%- can be even bigger. We’re looking at yields in the 12% range. Much like the municipal bond space, an MLP CEF will yield considerably more than a comparable ETF. The ability of a CEF to use leverage allows the fund to reduce its taxable liability even further.

Adding Some Energy Infrastructure CEFs

Like many illiquid and exotic asset classes, the closed-end fund structure lends itself to enhancing the benefits of energy infrastructure. Better tax management, higher yields, and use of use are just some of the hallmarks of using a cEF for MLP and energy infrastructure investment.

Now, there are some wrinkles in the fabric. At one point, there were over 130 different MLP and midstream-focused investment vehicles on the market- including a ton of CEFS. However, as the overall universe of MLPs has shrunk, so has the number. For example, Tortoise Investment recently rolled up several of its CEFs into an active ETF. Others, such as Clearbridge, have rolled all their midstream CEFs into just one fund.

However, despite the limited number of CEFs in the space today, they still are churning out substantial income and have plenty of appeal for investors looking to add the asset class to a portfolio.

MLP-Focused Closed-End Funds

These CEFs were selected based on their exposure to master limited partnerships and midstream asset classes. They are sorted by their YTD total return, which ranges from 2.5% to 15%. They have expenses between 4% and 16%, while their AUM ranges from $196M to $2.34B. They are currently yielding between 6.1% and 12.5%.

All in all, closed-end funds enhance weird asset classes. This is true for the midstream sector. MLPS simply works well within the CEF structure. With large yields, lower taxes, and other benefits, investors looking to add a dose of midstream to their portfolios will be very well suited in CEFs.

Bottom Line

With more attention being placed on infrastructure and midstream investments, closed-end funds should get the nod. Offering strong yields and a host of tax benefits, cEFs are a great way to add MPLs to a portfolio.