Attractively Priced for Income, Distribution Growth, Low Risk and Long-Term Distribution Stability
Underlying ex-energy MLP Index offers strong distribution income and growth potential with a compelling 14.12% annualized yield
Recent dip in ETN market value relative to 52-week high makes LMLP a compelling investment at current levels
Issuer UBS is an investment grade Swiss bank with minimal credit risk
The UBS ETRACS Monthly Pay 2xLeveraged Wells Fargo MLP Ex-Energy ETN (NYSE Arca: LMLP) is an exchange-traded note (ETN) that uses leverage to deliver a variable monthly coupon that is twice the cash distribution of its underlying Index – the Wells Fargo Master Limited Partnership Ex-Energy Index. LMLP offers sizable income upside with broad diversification across distribution paying Master Limited Partnerships (MLPs) across multiple sectors excluding the volatile energy sector. Leverage is reset on a monthly basis. LMLP is attractive because its fees of 0.85%, accrued daily, are well below other competing ETNs that charge higher fees but deliver lower returns.
MLPs are typically structured to deliver investment income from long-term fee-based contracts with foreseeable revenue streams and offer relatively lower risk than the market, especially if you exclude the volatile energy sector. Further, MLPs are typically structured as growth vehicles with asset dropdowns from sponsors and incentives to increase distributions (Incentive Distribution Rights), so MLP distributions tend to be stable and increase over time. As a result, 2x leveraged returns on non-energy MLPs offer compelling income upside with long-term visibility.
LMLP is an ETN (a credit instrument that pays a coupon), not an ETF, because the 1940 Investment Company Act limits leverage in ETFs.
3 Key Criteria – Non-Energy MLPs, $100+ Million Market Cap, 10% Weighting Limit
The ETN’s underlying Index – the Wells Fargo Master Limited Partnership Ex-Energy Index – seeks to measure the performance of all non-energy MLPs that trade on the New York Stock Exchange (NYSE), NYSE MKT or NASDAQ and have a market capitalization of at least $100 million at the time of inclusion. The Index is a modified market capitalization weighted index where a single MLP sponsor (issuer) may not exceed 10% of the total capitalization of the Index.
The underlying Index lets investors quickly capitalize on event-driven news and long-term trends and offers a diversified play for investors looking to get broad exposure to the MLP space.
If the Index constituents do not make distributions, LMLP investors will not receive coupon payments.
Recent Price Drop Gives ETN Attractive Valuation for New Investors
LMLP started trading on 06/24/2014 and has a 30-year term that ends 06/24/2044. It has 1 million shares outstanding and a market capitalization of $23.29 million.
The ETN began trading in June 2014. Assets have grown steadily since inception, reflecting solid investor demand. As of 11/21/2014, LMLP traded at $23.31, well below its 52-week high of $31.61, and offers compelling value at this level.
ETN Offers 14.12% Annualized Yield, Coupons Taxed as Ordinary Income
On 11/20/2014, the ETN paid a coupon of $0.2115 for an annualized yield of 14.12%. Since inception through the November 2014 coupon, the note has paid $0.9229 in coupons in 2014 year-to-date. The ETN’s annualized yield is based on 4x the three most-recent monthly coupon amounts.
The ETN is senior unsecured debt issued by UBS and backed by its credit. As a credit instrument, not a fund, the ETN offers coupon payments, not dividends. Though unsecured, it has minimal credit risk because of the strength of its sponsor, Swiss banking giant UBS.
As coupons, distributions are taxed as ordinary income. So while many of the Index’ constituents focus on tax efficiency, that efficiency is lost under the ETN structure but leverage enables twice the coupon.
Distributions Fluctuate Significantly From Month to Month
As the table above shows, the ETN’s distributions vary significantly from month to month, and reflect different quarterly distribution dates by the Index’s underlying components. The ETN and its underlying Index are fairly new products and do not have enough history for specific high payout months.
Moreover, as an ETN, LMLP is obligated to mimic 2x actual distribution payouts by the underlying Index components, and cannot smooth out payments. If a component of the index reduces dividends, the ETN too will reduce dividends, and vice versa.
Coupon Sensitivity to Net Asset Value
If the NAV of one or more Index components drops (or rises), the ETN will have to sell some (or buy more) of its holdings to maintain 2x leverage and this rebalancing will cause a drop (or gain) in coupon even if the dividend paid by the underlying component is unchanged.
LMLP Benefits – Strong Income Upside, 2x Leverage, Distribution Growth Upside, Diversification, Convenience
With LMLP, investors receive significant monthly income with a variable coupon that offers double the cash distributions made by the Index’ underlying constituents. The ETN uses leverage in a manner that individual investors may not be able to cost-effectively do themselves, and offers exposure to a broad range of non-energy MLPs that had a market cap of at least $100 million at the time of inclusion in the Index.
LMLP offers high income with reasonable, but not excessive, capital risk. Holdings include non-energy MLPs sponsored by major U.S. financial firms such as Apollo Global Management, Icahn and Carlyle. An ex-energy MLP-based ETN offers less than market risk, steady distributions, solid distribution growth potential (from dropdowns, organic growth) and long-term visibility.
LMLP Risks – Leverage, No Guarantee, Higher Volatility
LMLP is exposed to twice the monthly decline in the underlying Index, and potential risks include loss of capital. The note is senior unsecured debt issued by UBS, and not guaranteed by any third party; so the ETN’s market value will be impacted by the actual and perceived creditworthiness of UBS. A default by UBS could result in a loss of investment capital (but this is a low probability outcome).
The table below shows the effects of 2x leverage. The ETN’s 1-month return is more than twice the underlying index but a 1.58% drop in the Index caused a 2.50% drop in LMLP returns. However, a subsequent rebound will improve 6-month returns relative to the underlying Index.
The ETN has higher price volatility (relative to the underlying Index) due to the 2x leverage (higher leverage implies higher price volatility) deployed.
Returns will be impacted by macro-economic and industry specific factors that impact performance and distributions made by the underlying MLPs.
UBS requires redemption of at least 50,000 ETNs for repurchase eligibility, so liquidity may be limited.
Potential Automatic Acceleration (Low Probability)
If the indicative value of the ETN drops to $5 or less on any trading day or decreases 60% in value from the closing indicative value on the previous Monthly Valuation Date, the ETN will be automatically accelerated and mandatorily redeemed by UBS, and investors will receive a cash payment that could be less than $5 per security or even zero if ETN prices continue to drop. The probability of this outcome is low.
UBS’s Call Right (Low Probability)
UBS may redeem all outstanding ETNs at any time on or after June 29, 2015. If UBS exercises its Call Right, the Call Settlement Amount may be less than the Principal Amount of the ETNs.
The ETN has call features to protect the issuer, UBS, from a sharp drop in the underlying Index components at a rate that may make it difficult to rebalance components and may put the ETN in a negative equity position. This is equivalent to a broker having the right to liquidate positions should an investor fail to meet a margin call. As such, LMLP’s call option protects the issuer from downside risk but has no intrinsic economic value. Aside from that, UBS has no incentive to call the ETN if it’s trading at reasonable levels.
The table below shows the Index’s 18 constituents as of November 2014, with marquee asset management names reflecting good diversification by asset manager, yield and MLP sector.
LMLP offers compelling income upside with the added stability and distribution growth upside that non-energy MLPs offer. The ETN is also quite attractive at current levels due to a sizable drop in market value relative to its 52-week high. LMLP is backed by investment-grade Swiss banking giant UBS and credit risk is minimal. LMLP is an excellent way to add income based on a diversified set of America’s top MLPs without exposure to the volatile energy sector.