BND - Well-Covered 7-10% Yields To Hide From Rising Rates Unrest And Recession

2023-10-20 15:51:17 ET

Summary

• Rising long-term interest rates, unrest in the Middle East, and fears of an economic downturn are leading concerns for investors right now.
• We share what sector we believe is the best possible investment in the current environment.
• We also share two of our top picks in that sector.

Three of the biggest concerns facing investors right now are rising long-term interest rates, growing unrest in the Middle East, and growing fears of a meaningful economic downturn. You can see these three concerns manifesting themselves in the following chart, which shows long-term interest rates surging in recent months, the energy sector (XLE) soaring due to concerns that the war between Israel and Hamas may expand to include major oil exporters like Iran and even Saudi Arabia, and the inverted yield curve indicating that a recession is highly likely in the near future:

As a result, many investors are dumping stocks - particularly interest rate sensitive dividend stocks - in favor of the greater safety offered by bonds, particularly short-term treasuries ( SGOV ), which enjoy safety from both interest rate fluctuations and recessions while still offering a fairly attractive 5%+ yield due to the inversion of the yield curve.

While we certainly understand why investors want to take this path, we believe that there is an even better opportunity that is poised to survive the three-headed monster of rising long-term interest rates, rising oil prices, and a likely economic downturn while offering a much higher yield and solid long-term growth potential. In this article, we will discuss this opportunity and share two of our six top picks of the moment in the sector.

The Ultimate High Yield Investment In The Current Environment

We believe that energy midstream infrastructure (AMLP) is the ultimate high-yield investment in the current environment for the following reasons:

1. It offers yields that are well in excess of long-term interest rates, providing a sufficient incentive for investors to take on the additional risk of equities and invest in the space.
2. Many midstream balance sheets are in excellent shape today, thanks to the motivation provided by the ESG investing movement when it starved the sector of new capital. This forced midstream management teams to significantly pare back capital returns to investors and high-grade capital expenditures in favor of rapidly deleveraging balance sheets. Now, with interest rates rapidly rising, these midstream businesses are in great shape to weather the storm relatively unaffected as they have few near-term maturities, low leverage ratios, and plenty of free cash flow to be able to pay down maturing debt if they so choose.
3. The long-term, fixed-fee, take-or-pay structure of the vast majority of midstream contracts makes their cash flows quite stable and defensive, regardless of macroeconomic conditions or energy prices. This helps to mitigate concerns that energy prices may collapse in the event of a global economic downturn.
4. Finally, midstream equities - as part of the energy sector - tend to move higher with the price of oil, even if their cash flows are not significantly impacted by energy price volatility in the near term. As a result, if the war in the Middle East expands further and drives the price of oil higher, we expect midstream stocks to rise along with other energy stocks. While the long-term intrinsic value boost to midstream stocks from such an event will likely be fairly minimal, the likely rising market valuation of stocks in the sector will serve as a nice ballast for investor portfolios given that many other sectors of the market will likely be in decline during such a scenario. Investors can always capitalize on this dynamic by engaging in some strategic capital recycling if they so desire by selling some of their appreciating midstream assets and using the proceeds to buy discounted stocks elsewhere which may present a better value at that point.

With these strengths in mind, here are two midstream businesses that we believe are particularly well-positioned for the three-headed monster facing the markets today:

#1. Enterprise Products Partners (EPD)

EPD checks all the boxes in the current environment:

EPD offers an attractive current yield of 7.3%, which is significantly higher than the 5% yield currently being offered by 10-year treasuries. Moreover, EPD's distribution is considered very safe as it has never been cut, is expected to be covered 1.74x by 2023 distributable cash flow, and has increased every year for 25 consecutive years. Lately, management has been growing its distribution at a ~5% CAGR and appears well-positioned to continue growing it at that rate for years to come. This growth rate is well in excess of the current rate of inflation (on both a headline and core CPI basis) as well as of the Federal Reserve's long-term inflation rate target of 2%.

The company also boasts an A- credit rating, the best in the energy midstream sector. With a low leverage ratio of 3.0x, $4 billion in liquidity, and a stable cash flow profile due to its diversified, highly contracted business model, EPD has little to worry about when it comes to meeting its financial obligations. Moreover, its low leverage ratio, very well-laddered debt maturities (weighted average term to maturity of 19.7 years on its debt with a whopping 51% not maturing for 30 or more years), 96.7% of its debt being fixed interest rate, significant liquidity, and substantial free cash flow generation leave it well-positioned to pay off debt as it matures should it decide it does not want to refinance it at higher interest rates. Alternatively, should it decide to refinance its debt, its A- credit rating positions it to do so with relative ease.

Last, but not least, for a company with its impressive list of credentials and robust fundamentals, EPD is fairly inexpensive at the moment. In addition to its juicy distribution yield and solid growth profile, EPD's EV/EBITDA ratio is only 9.49x, which is well below its 10-year average of 12.24x. This indicates that EPD could generate attractive capital appreciation for unitholders alongside its attractive and growing distribution.

#2. Energy Transfer (ET)

Like EPD, ET also has a lot to offer investors in the current environment:

It has a stable cash flow profile thanks to its significant diversification by geography and energy commodity as well as the well-contracted nature of its cash flows. Approximately 90% of its expected adjusted 2023 EBITDA comes from commodity price-resistant long-term fee-based contracts, making its business model fairly defensive and resilient against macro volatility.

Moreover, ET's balance sheet recently received an upgrade to BBB from S&P, reflecting its substantial deleveraging progress over the past several years. Moving forward, management expects to manage its debt burden and capital investments in a manner that keeps the leverage ratio within the company's 4.0x-4.5x target range for the foreseeable future. However, ET could quite easily use its free cash flow net of distributions to pay off most - if not all - of its maturing debt in the coming years if it so chose and decided to cut back dramatically on growth spending and distribution growth. While management is likely not going to take that path, it is nice that it has that option in the event that interest rates soar materially higher.

Finally, ET's distribution is very attractive and well-covered by cash flows, making it attractive to investors looking for equity exposure without taking on excessive risk and yet still wanting to generate a substantial yield premium to what is currently being offered by cash and treasuries. With a 9% NTM distribution yield, an expected 1.95x 2023 distributable cash flow coverage ratio, and a projected 3-5% CAGR on the distribution for the foreseeable future, ET offers investors a compelling combination of yield, growth, and safety. With an EV/EBITDA of just 7.8x, ET remains one of the cheapest midstream businesses on the market today and - compared to its 10-year average of 10.72x - it also offers investors substantial valuation multiple expansion potential.

Investor Takeaway

Currently, investors are grappling with how to handle three significant challenges to their portfolios: the upward trajectory of long-term interest rates, escalating tensions in the Middle East, and mounting concern over a potential economic downturn. While short-term treasuries through funds like SGOV can protect an investor's principal against recession and rising interest rates while still delivering a real yield net of current inflation rates, the total return is still nothing special at only slightly above 5%. Moreover, the potential for soaring energy costs remains unhedged in such a scenario.

Another option is to invest in the energy sector through funds like XLE or via buying the stock of a major oil producer like Exxon Mobil (XOM) or Chevron (CVX). However, you are then exposing yourself to the potential for a dramatic decline in energy prices if a recession were to hit. Of course, triple net lease REITs like Realty Income (O), utility stocks (XLU), and long-term bonds (BND) can protect against the downside of a recession while offering an attractive yield in most cases. However, they fail to guard against further increases in long-term interest rates or soaring energy prices.

As a result, we believe that investing in midstream infrastructure businesses that offer very attractive and sustainable distribution yields, have very strong balance sheets with relatively little exposure to rising interest rates, and boast recession and energy price volatility-resistant business models is one of the best moves an investor can make today. Based on these criteria, EPD and ET are among the best options available right now for investors who are willing and able to deal with K-1 tax forms.

For further details see: