Let's work on the premise that the Federal Reserve will raise interest rates this year, do so multiple times and commence the tightening cycle in March.
Of course, surprises are always a possibility, but with inflation persistent and showing no signs of relenting anytime soon, the Fed's hand is forced and rate hikes are likely a foregone conclusion at this point. With that in mind, conversing with clients about assets with track records of performing well or outperforming when rates rise is a good near-term idea.
That conversation often revolves around financial services stocks and rightfully so. Higher interest rates boost banks' net interest margins, but other groups are responsive to the specter of Fed tightening. Energy is a prime example. Just look at the S&P 500 Energy Index. The widely followed energy gauge is higher by 16.7% year-to-date and “year-to-date” means just 11 trading days to this point.
That's potentially good news for clients because energy also offers credibility as an inflation-fighting sector. Add to that, one of the prime income-generating corners of the energy patch – midstream – could prove sturdier-than-expected when rates rise this year.
Midstream Factors to Consider
Something that many clients don't understand as to why Fed tightening crimps some sectors and not others – and this is why they have advisors – is that higher yields on conservative government debt can compel investors to depart high dividend sectors, such as real estate and utilities.
However, in the case of midstream, the dividend yields are so far beyond broad fixed income benchmarks that it's unlikely master limited partnerships (MLPs) will succumb to rampant selling simply because of a few rate increases. At the end of 2021, the Alerian Midstream Energy Index (AMNA) and Alerian MLP Index (AMZ) were yielding 6.3% and 7.9% respectively. Compare to that the piddly 1.8% on the Bloomberg Barclays Aggregate Bond Index.
Adding to the case for MLPs in a rising rate environment is that these operators are as financially sturdy as they have been in years. Following years of profligate spending and some ill-fated acquisitions, midstream energy are improving balance sheets and tightening purse strings, potentially providing some insulation against rising rates.
“Leverage has trended lower over time as many companies have focused on debt reduction in recent years. Additionally, midstream capital spending has come down meaningfully since peaking in 2018 or 2019 when companies were investing heavily to facilitate production growth,” according to Alerian research.
Obviously, MLPs need to outperform real estate investment trusts (REITs) and utilities in rising rates environments to make it worthwhile to embrace the asset class during tightening cycles. While the history is limited, it favors midstream energy.
“Overall, MLPs and midstream outperformed utilities and REITs in periods where Treasury yields were increasing,” adds Alerian.
Year-to-date, the aforementioned MLP indexes are beating 10-year Treasury yields and REITs and utilities.
Compelling Midstream Opportunity
As advisors well know, clients are clamoring for more income. Alone, that makes midstream appealing today, but the interest rate situation can be icing on the cake.
“While it is difficult to isolate the impact of a rising interest rate environment on midstream equity performance, correlation data and recent historical performance should help allay investor concerns that rising rates may have a negative impact on midstream performance, particularly relative to utilities and REITs,” concludes Alerian.
Even interest rates don't rise, midstream energy offers inflation protection and potential upside derived from rising oil prices, making the asset class appealing to a broad audience of clients.
Related: Mid, Small Caps Worked in 2021 and Can Do it Again in 2022