In 1986, the U.S. government created a tax loophole for a handful of special American businesses. The government wanted to give these businesses a big incentive to expand the national infrastructure. So it gave them an incredible advantage: They don’t have to pay corporate tax.

Today, 88 businesses qualify for this exemption under the government’s rules. They are all publicly traded. The government calls these stocks “master limited partnerships” (MLPs) or “publicly traded partnerships” (PTPs).

Eighty-five percent of MLPs are in the energy business. Two-thirds of these energy companies operate pipelines. The rest run miscellaneous “midstream” energy businesses – things like refining, compressing, pumping, and field gathering. Only 15% of MLPs are outside the energy sector.

You likely know several MLPs already. Kinder Morgan used to be part of Enron. It’s an MLP. And though you’ve probably heard of Blackstone Group and its private-equity operations, you may not know Blackstone is also structured as an MLP. Carl Icahn’s business – Icahn Enterprises – is an MLP, too. (For a full list of MLPs, see the website of the National Association of Publicly Traded Partnerships at www.naptp.org.)

I like MLPs as an investment. One of the secrets of income investing is avoiding tax. When you avoid tax, you generate higher returns without taking on more risk. Besides, MLPs invest in infrastructure. The population of the United States grows every year. Population growth supports 8% average annual MLP market growth.

But here’s the thing: I think MLPs are going to beat almost all other income investments over the next two years for another reason altogether:

Canada.

The income-trust market in Canada is almost identical to the MLP sector in the United States. Canadian income trusts pay no tax, they distribute all their earnings in dividends, and they operate mostly in the commodity and energy sectors.

In other words, MLPs compete directly with Canadian income trusts for investment.

Millions of income investors, pension funds, retirees, and other dividend hogs have enjoyed these trusts’ high dividends over the last 20 years.

But on October 31, 2006, the Canadian government changed the law. It ended the Canadian income-trust structure. Existing trusts have until January 1, 2011 to convert back to corporations, begin paying corporate taxes again, and cut their dividends.

MLPs are the perfect substitute. Yield hogs will turn their attention to MLPs as the 2011 deadline approaches.

Right now, MLPs are paying 7.4%. A 10-year Treasury note pays only 4%. The “spread,” or difference, is 3.4%. This spread is the largest it’s been in five years. That means MLPs are as cheap as they’ve been since 2003.

North American Pipeline MLP Yields Versus
10-Year Treasury Bonds

If nothing changes, MLPs will keep generating 7.4% dividend yields. Add that to 8% industry growth, and we’ll make total annual returns of 16% – matching returns of the last 18 years.

But when you take into account the demise of the Canadian income trusts… I think MLP investors could easily see 25% annual returns over the next couple of years.

Good investing,

Tom

P.S. I’ve found the best way to invest in MLPs. It’s a basket of these investments, it pays a 6.5% dividend yield… and you can buy it at a discount to its net asset value. Here’s something else: You won’t have to worry about tax paperwork associated with MLPs because the SEC considers this investment a regular stock for tax purposes…

I recently published a report on this investment for readers of my advisory The 12% Letter. Click here to learn more about The 12% Letter.

Source: Canada’s Loss Will Make These U.S. Stocks Soar