Investors seeking to access the energy infrastructure space through passively managed vehicles have a menu of options, including half a dozen passive ETFs. Beyond ETFs, investors may also consider exchange-traded notes (ETNs). The first passive exchange-traded product to provide exposure to Master Limited Partnerships (MLPs) was an ETN. ETNs still represent a useful tool in portfolio construction today. Learn more about what an ETN is, its use cases, and the menu of midstream/MLP ETNs.
Note that this article should not be considered tax advice, and investors should consult with their tax advisor for guidance specific to their situation.
MLP ETNs 101
Exchange traded notes are unsecured debt obligations of an issuing bank, which agrees to provide investors with a specified return typically based on an index. ETNs are essentially debt securities that trade on an exchange. Of note, investors in ETNs are exposed to the credit risk of the issuer.
Like an ETF, an ETN can provide exposure to a basket of MLPs without the potential headaches of a Schedule K-1. (Recall, as pass-through entities, directly owning MLPs will result in a Schedule K-1 for taxes.) A key advantage of ETNs relative to ETFs is that they have little to no tracking error.
Energy infrastructure ETNs typically pay a variable, quarterly coupon based on the payouts of the underlying index constituents. Investors can see historical coupon payments and yield information on an ETN’s website. Importantly, coupons are treated as ordinary income for tax purposes.
A midstream ETN may take its fee out of the coupons, lowering the yield, or out of its net asset value (NAV). It is more common for the fee to be taken from NAV. Issuance documents will specify how the fee is collected.
When Might an Investor Prefer an ETN?
There are a few considerations to keep in mind when determining whether to access the midstream/MLP space using an ETN. First, an investor should be comfortable with the credit risk of the issuing bank and prefer a passive investment strategy given that ETNs are based on indexes. Investors should ensure the underlying index matches their desired exposure.
Another important determinant is the type of account being used. Midstream ETNs are best-suited for tax-advantaged accounts since coupons are taxed at ordinary rates (i.e., 37% for the highest tax bracket).
Additionally, an investor may prefer an ETN if they are expecting significant price appreciation for the underlying index. An ETF, mutual fund, or other fund that owns more than 25% MLPs will be taxed as a corporation and may experience tax drag at the fund level as its holdings gain, adding to tracking error. ETNs have little to no tracking error, because the issuer agrees to pay the return on the index (less fees).
Midstream ETNs Mostly Provide MLP Exposure
The number of midstream ETNs has declined over time — read more. Three ETNs that included MLPs and corporations were redeemed late last year. The remaining midstream ETNs mostly track MLP indexes.
Specifically, we estimate there are now five energy infrastructure ETNs issued by J.P. Morgan, UBS, and Barclays with combined net assets of $1.5 billion as of January 31. For context, the six passive midstream ETFs had over $16 billion in assets as of January 31, led by the Alerian MLP ETF (AMLP).
Digging into the five ETNs, three track the Alerian MLP Index (AMZ), including one with 1.5x leverage. One ETN tracks the Alerian MLP Infrastructure Index (AMZI). The largest energy infrastructure ETN is the JPMorgan Alerian MLP Index ETN (AMJB), which tracks AMZ. Fees for the five ETNs range from 0.80%-0.95%, with the leveraged ETN having an additional financing fee.
ETNs tracking an MLP index will tend to offer higher yields than an index tracking MLPs and corporations. The yield for an MLP ETN will also depend on whether the fee is taken from the coupon or the NAV. For context, as of February 5, AMZ and AMZI were yielding 6.6% and 6.8%, respectively.
Bottom Line:
An ETN is likely best-suited for a midstream/MLP investor allocating in a tax-advantaged account that is comfortable with the credit risk of the issuer and seeking to minimize tracking error.
AMZ is the underlying index for the JPMCFC Alerian MLP Index ETN (AMJB), the ETRACS Alerian MLP Index ETN Series B (AMUB), and the ETRACS Quarterly Pay 1.5x Leveraged Alerian MLP Index ETN (MLPR). AMZI is the underlying index for the Alerian MLP ETF (AMLP) and the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB).
Related research:
ETFs, CEFs & More: MLP Investment Products Evolve.
Accessing MLPs/Midstream through ETNs
For more news, information, and analysis, visit the Energy Infrastructure Channel.
VettaFi LLC (“VettaFi”) is the index provider for AMJB, AMUB, MLPR, AMLP, and MLPB, for which it receives an index licensing fee. However, AMJB, AMUB, MLPR, AMLP, and MLPB are not issued, sponsored, endorsed or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing or trading of AMJB, AMUB, MLPR, AMLP, and MLPB.
