I just read this story from LaTimes.com. Some guy had an equity of some $275K in his home, and he spent through it all. Here are some interesting excerpts from that link:

In the first eight months of 2006, even as the real estate market began to weaken amid fears of a downturn, the appeal increased again. Nearly 1 in 3 California loan applicants are now choosing them. The state boasts about 580,000 active pay option mortgages, about half the U.S. total.

Hertzberg’s home equity paid off his credit cards, financed trips around the world that allowed him to indulge his passion for photography, bought a $32,000 Toyota Avalon and enabled some lousy investments. He bought dot-com stocks and lost money. To recoup those losses, he bought commodities — and lost money faster.

But the day of reckoning is arriving early. By paying the minimum, Hertzberg has increased the size of his loan in a little over a year from $320,000 to $332,616. His lender, Calabasas-based Countrywide Financial Corp., recently sent him a letter warning that when his loan hits 115% of its original size he’ll run out of credit with the company.

The article said that his “life line” will run out in two years. But my calculation shows that it should be another four years (about 3% every year). Maybe I’m not using the correct current interest rate. In any case, such loans get recast every five years. So looks like he delayed his time bomb to 2010, assuming that he can get through annual 7.5% increase in the minimum payment year after year.

If you think his case through, don’t you wonder where the funny money comes and goes? It’s a house in 1995, and it’s the same house, but older in 2006. Just the valuation of the house has changed, but no economic productivity has increased. The flood of cheap money is coming from Asian savers and central banks, while Americans spent thru it. When Asian savers retire and start to withdraw money from the system, where will the “money” which is already spent come from?

When the wealth of a society is created primarily based upon a higher valuation of the assets, the wealth can go away as easily as it comes (when the valuation changes).

I’m guessing that at the end, the creditors/savers cannot get their saved (paper) money back, since the debtors/spenders would either have no money to pay back, or print more worthless ever-depreciating paper money for the savers.

As far as the real estate market goes, I’m still in the camp of slowly unwinding from the height, since the lending standards have not tightened much (this guy Hertzberg was able to refinance last fall). The housing market may rise up again if

1. wage income inflation catches up with the past housing inflation, or
2. long term interest rate falls even further, hard to imagine, but that’s the current forecast by the bond king Bill Gross (down to 3%).

I’m guessing that scenario #1 is more likely, if $US undergoes an orderly decline. But the outsourcing trends will probably cap the wage increases.

I don’t believe that scenario #2 will happen. I believe that along with the turn of housing market, the bond market has also turned. The sentiments among foreign central banks have turned, and diversification out of $US has been the key messages.

Better open your Bank CD now rather than later. If you don’t need to use the money, and don’t want to put the money into stock market or any investment, I would suggest you to open a CD that is longer than 1 year. Here is the link for 1-year CD and 2-year CD from BankRate.com. The interest rates in money market accounts will immediately come down once Fed starts to cut short term interest rates.

The current bond yields are indicating a strong possibility of interest rate cut at the end of this year or early next year. 10-year treasury bond yield is down at 4.6%, while 30-year treasury bond yield is at 4.73%. The Fed short term rate however is at 5.25%. Make any sense to you? This is the so called inverted yield curve which is forecasting an economic slowdown and possibly a recession if Fed doesn’t cut rate soon.

It looks like we are back in the goldilocks economy. Everything appears to be great. $US is not falling, but actually rallied. Mortgage rates will be down because of the fall in treasury bond yields. The bond yields can allow the stock market to sport with a higher P/E ratio, relative to the unattractive bonds. Crude oils has fallen big time, and same for gold, while stock market indexes are setting new yearly highs if not all time high. I almost want to say that it’s too good to be true. Assuming that the price for commodity stays down, and Fed can stop housing to slide, we will have a soft landing.

According to Hoenig, one of the Fed officials, inflation has peaked, and will decline going forward. But I am not so sure at all. Yes, Fed wants us to believe that inflation has peaked and is totally under control. With such belief, bond market can stay strong, and Fed doesn’t need to keep increasing interest rates.

I believe all signs are still pointing to greater inflation. That is the only way out for a debtor nation like US. The only game in town is the confidence game. Keeping the confidence up, then US dollar and bond markets will be strong, and therefore stock and housing market will not weaken too much.

Here are the major risk factors that will affect the bond performance:

1. Inflation risk:
   Your invested principal will most likely not be able to buy as much at the time of redemption due to years of inflation. Those are actual buying power lost. Don’t kid yourself that you can’t lose money when investing in actual bonds. Yes, all the money may be returned to you, but a $5 burger may cost you $10 much later. Your money dominated in the numbers of burgers would have lost 50% of its value. To me, this is really the one of the biggest risk.
2. Interest risk:
   The interest rate can go up and down during the time when your money is invested in bonds. When the economy weakens, the interest rates tend to go down because the inflation rate tends to go down. With less risk due to inflation, the price of bonds will go higher, and the yield goes lower. When the economy is strong, the interest rates & bond yields tend to go higher. As I have explained at the very top, you want to buy low and sell high (if not selling at the same price).
3. Currency risk:
   Instead of bonds in $US, issued by US government, municipals, or corporations, there are foreign bonds that you can buy (assuming you live in the US). The foreign bonds may have a higher or lower bond yield, depending on the inflation/interest rate in that particular country. Just to give you a general idea, Japan is at 0.25%, Euro 2.75%, UK 4.75%, Swiss 1.5%, New Zealand 7.25%, and US 5.25%. You may be able to get more interests if you invest in other countries. You can look at the world interest rate here. However, their currency may strengthen or weaken by the time when you decide to sell your bond, depending on the state of economy in that particular country at that time. You may incur a gain or loss due to currency exchange rate.
4. Credit risk:
   If the issuer defaults on the bond, or declare bankruptcy, your bond value will plunge in the trading market. If it’s bankrupt, you will be in the line of every creditor in the bankruptcy court.

In summary, when investing in bonds, it is always true that by taking more risks, you will get more interest yields. Risks are always proportional to the effective yields (on an after-tax and currency-exchage-rate adjusted basis). Risks for bonds include both credit risk, currency risk, and inflation/interest rate risk. Each factor of the risk should be carefully evaluated when investing in bonds for success.

At Fidelity, they have an excellent educational materials on fixed income investing or bonds. If you’re serious about investing in bonds, you should definitely take a look at their website.

Here are all the posts in the same bond investing series:

1. Intro to Investing in Bonds: Fundamentals
2. Intro to Investing in Bonds: How-to
3. Intro to Investing in Bonds: Risk Factors
4. Reasons for (Not) Investing in Bonds

Most people invest in bonds because they want to have stable fixed income. Because the performance of bonds is very stable, it also serves to reduce the volatility of the overall portfolio. Depending on the weighting from 0% to 100%, you can reduce your stock volatility correspondingly. With regular re-balancing between your stocks and bonds, you should be able to “sell high and buy low” in your stock portion, and use your bonds as a stable source of income.

Everything sounds good so far. But the most attractive feature of fixed income is also the biggest problem for bonds. The income is FIXED. It does NOT increase as time goes on, and as inflation keeps reducing your principle and interests into nothingness. Since inflation is almost always there, you got a real problem especially when you investing long term in the long term bonds.

Normally, this problem is resolved through obtaining higher interest yield on your bonds to compensate for your inflation risk. Assuming that your obtained yield is always higher than the inflation rate, you will not have a problem. Your actual income from bonds however should be on an after-inflation basis, and after-tax for that matter.

Vice versa, if economy is undergoing a phase of deflation (usually caused by economic recession or depression), it is very advantageous to invest in bonds. Not only you get a fixed income while everything is falling off the cliff, but also your purchasing power of your principle just keeps getting better. From 1980 to 2001, US and the world in general have experienced one of the best era in terms of economic prosperity. It was an extended era where nominal inflation rate is relatively low while the economic expansion keeps going strong. In the spring of 1980, when Fed Chairman Volker hiked interest rate to stratospheric 15% in the attempt to save $US from further depreciation and to put a stop on double digits inflation rate, it was actually close to the peak of inflation. At the peak of inflation (or interest rate usually), the bonds reaches a very low value, while the bond yield reaches a very high point, it is the best time to invest in bonds. At that time, if you have invested in bonds, you could have locked in some 10% to 15% annual yield rate for the length of the bond you purchased (like 30 year treasury bonds).

After almost 20 years of bull market in bonds, I personally believe that we are embarking an era where inflation rate is heightened (at least for US), which will force the bond interest rate to stay high if not going higher. Study the following inflation chart from inflationdata.com, a great site for historical data research:

You can see that inflation rate has broken the downward trend line, and started to trend up.

In the coming years, I believe that bonds are probably not the best investment because of the huge debt overhang on $US. To go in the reverse gear on investing bonds, one can actually “short bonds” by borrowing a big amount of a fixed term loan, such as home mortgage. Assuming that bonds are not good investment, “shorting bonds” by having a mortgage will be actually good (assuming that you have the capability of sustaining the mortgage payment, even when you lose your job for an extended period). The next thing which is a more risky move is to invest in the anti-bond investment, which is gold & silver, and natural resources in general. You can click on both to find out how to invest in them. In any cases, I would suggest that instead of investing your money in bonds which generate a fixed income, you should probably invest into a dividend-paying stock, preferably tied its dividends to the price of natural resources. Yes, it may go up and down a lot more. But in the long term, your dividends can go up as the inflation goes up and the price of the natural resources goes up too. Here is a list of high yield dividend stocks, yield from 6%+ to almost 20%, mostly tying their dividends to price of gas/oil, or its related business.

Protection of your inflation-adjusted principle is the most important thing in investing. There are times for bonds, but probably not now. You may argue your case for investing in TIPS, treasury inflation-protected securities which have interest yields indexed to CPI. But I cannot trust a Fed that hides M3 money statistics, nor a government that uses hedonic adjustments on CPI to bail you out of inflation. In case you still decide to invest in them (for a short time), here are all the posts in the same bond investing series:

1. Intro to Investing in Bonds: Fundamentals
2. Intro to Investing in Bonds: How-to
3. Intro to Investing in Bonds: Risk Factors
4. Reasons for (Not) Investing in Bonds

There are a couple of ways that you can invest in bonds:

1. Buying and own bonds directly:

   This strategy exposes you most to the credit quality of the bond. If you have a lot of money, you can buy a diversified portfolio of bonds, and reduce a lot of the credit quality risk. Or you can buy very high quality bonds (ASSUMING that credit ratings are correct. How many times they downgrade the credit rating only after-the-fact?).

   But owning bonds directly give you one of the best things that are not available in mutul funds, except closed ended funds. When you own a bond directly, it’s like investing in the mutual bond fund, with a free put option. The “free put option” allows you to eventually sell your bond to redeem all of your money from the issuer without any loss (in the number, but not in buying power). The “free put option” also grows in value through time. Because as the bond approaches the time of maturity, your long term bond will gradually transform into an intermediate term bond, and then a short term bond at the end. Since normally, the yield curve is not inverted, and that short term bond has a lower effective interest rate than long term bonds, it means that eventually you can benefit from the gradual transition of higher interest rates going towards lower interest rates (which equals gain in the bond prices). Now, of course, the foremost assumption of buying individual bonds is that you don’t need that money any time soon (and I mean years, if not decades). Well, of course, you can always sell your bond when you need money, but your “free put option” will not mean anything for a short term trade. For people with a lot of money that they think they will never need in the short term, this is a good strategy to make up a portfolio with individual bonds instead of buying bond mutual funds.

2. Buying a bond mutual fund:

   You can research for your bond mutual funds using the mutual fund screener at Yahoo’s finance. Vanguard mutual funds are usually pretty good and close to the lowest costs. In terms of specifics, I only want to say that you can enter any bond mutual fund symbols in Yahoo’s quote, clicked on Holdings at the left column, and scroll all the way down to the bottom. There are 3 MOST IMPORTANT numbers there: Maturity, Duration, Credit Quality. The average maturity is the capital weighted average time to maturity. The average duration is a better number that gives you an idea of how much the fund may lose when the interest rate goes up by 1% at the comparable length of bond yields. Here is an example on VWEHX.The meanings of each are explained here. I use the maturity & duration to evaluate my interst rate risk, and I usually prefer a relatively higher credit quality compared to industry average.

3. Buying a bond ETF:

   Here are some bond ETF that you can buy: TLT (for long term US bonds, 20+ years), TIP (TIPS bond), LQD (investment grade corporate bonds), IEF (intermediate term US bonds, 7-10 years), SHY (short term US bonds, 1-3 years). All of these ETF bonds pay monthly interest. My only minor problem with these ETFs is that these interests are supposedly to be state tax-exempt (except LQD), but your brokerage houses may report them incorrectly as un-qualified dividends instead. So you may get a little state tax bite, unless you get the brokerage house to change their 1099 form.

4. Buying TIPS treasury:

   TIPS stands for Treasury Inflation-Protected Securities. These bonds pay an interest rate of CPI + a small interest premium. TIPS are offered starting in 1997, and you can buy them directly from TreasuryDirect. While it is claimed as having protection against inflation, I think it’s more of a government bond to pay you cheaper yields under a hedonically adjusted CPI. Most of the time the CPI reported is lower than the real inflation rate. BankRate.com has a really good article on TIPS. You should check it out if you want to invest in TIPS.

5. Buying a closed end fund:

   One of the disadvantage of buying a closed end fund is that liquidity volume is rather poor. Because of that, you tend to pay a little more due to bid/ask spread. But the biggest advantage with buying a closed end fund is that there are many funds that structure their bond investments such that they will return the original cash back to the fund holder at a certain date. This makes them to be like an actual bond with the “free put option” that I mentioned above. Instead of perpetually investing back to the same type of bonds, they will make sure that all bonds will return cash by such date. Normally these funds are called “Limited Duration”, instead of “Perpetual”. BlackRock has a lot of offering for these types of investments. For example, BFO, BlackRock Florida Municipal 2020 term trust is designed to return $15 per share back to investor at about year 2020. There are so many offerings from BlackRock, Merill Lynch, Nuveen, Eaton Vance, and Colonial that I won’t list them all here. You can use closed-endfunds.com website to search through all these bond fund information.
   These closed end funds trade like stock shares. You can simply buy them from any brokerage houses.

6. Buying a floating rate fund:

   A floating rate fund is good when the short term interest rates are rising. This is a good investment in a rising rate environment in which most other bonds will have a tough time preserving capitals. This kind of fund invest in short term securities and manage to have the fund yield to go along with the prevailing short-term interest rate. Keeping their money farily liquid, they can easily re-invest the returned capital quickly to another higher yield short-term bond. However, because Fed is probably done with rate hike, I don’t think floating rate fund is a good idea. You don’t want to float down your interest rate. Rather you should lock in your rate in a bank CD.

Here are all the posts in the same bond investing series:

1. Intro to Investing in Bonds: Fundamentals
2. Intro to Investing in Bonds: How-to
3. Intro to Investing in Bonds: Risk Factors
4. Reasons for (Not) Investing in Bonds

Yes, I believe so. Fed almost always never surprised the stock market negatively since March of 2000. Since the Fed futures indicates a higher probability of rate pause, I believe Fed will oblige. If markets can use this opportunity to overcome the resistance of 1280 at S&P 500, that will be really good at least in the short term. Otherwise, the failure to take over that level may mean more churning and grinding down towards the 4-year cycle low in September of 2006.

What does this mean for the mortgage market? While I agree with Peter Schiff somewhat that mortgage rates may move higher instead, I don’t agree with his timeframe (by the way, he is always on the excessive bearish side). It has been fairly obvious that UK is “in bed” with US Fed by not only selling their gold reserves to push down gold (at the low points about $200ish of gold markets), but also raising their stakes of US treasury to help US fight the decline in $US. This article from financialsense showed that the major buyers who have taken the slack from China & Japan are UK, and accounts at Cayman islands. The author guessed that accounts at Cayman islands are not for hedge funds, but rather owned by US Fed Reserve. I concur. With a couple of trillion dollars in mortgage market coming up for adjustment in interest rates for their ARM terms, the last thing US Fed wants is to have a high mortgage rate. In fact, both 10-year and 30-year treasury bonds have recently (and finally) moved back to January level of this year. 10-year treasury actually broke the level of 5%, a very bullish sign for both stock and bond markets. I checked a couple of mortgage sites for mortgage interest rates, and this lower yields of treasury have already been reflected at the retail mortgage level.

So armed with these data, I believe that in the short term, Fed may engineer a lower yields in treasury market by buying their own issued bonds with newly printed money, even if it’s at the expense of exchange rate of $US. Remember that such actions have little to bullish effects on the bond market, while they are very detrimental to the bond market and $US in the long term. In fact, long term inflation is exactly what Fed needs to order for US economy. Without inflation, there is no chance for all levels of debt holders, consumers or governments, to repay all these debts. When a respected Federal Reserve governor (at St. Lious) calculates that US real fiscal gap is 65.9 trillion dollars, and questioning whether US is effectively bankrupt, you know that things are really bad, and I mean REALLY bad.

Before you invest in bonds, you should learn some fundamentals related to bonds:

1. Yield & its relation to Price:

   This is one of the most fundamental thing that novice investors can get confused. When the (effective) yield of a bond or bond mutual fund goes higher, the actual price goes lower; when the yield goes lower, the price goes higher. Because the paid out yields are already determined at the time of the issue of the bonds, the interest pay-outs are fixed by the term of the issue, while the actual price of the bonds can fluctuate. So when the price of these original bonds go down, its effective yields actually go up (because you pay less money for that fixed interest payout). And vice versa, when the price of bonds go up, the interest rates go down.

   Once you understand this concept (you may need to repeat it in your head a couple of times higher yields = lower prices and lower yields = higher prices, or at least that’s what I did), you need to understand the next step about bond investing: you want to buy low and sell high (yeah, of course) by investing your money into bonds when the interest yields will be going DOWN so that by the time when the interest yields stop going down, you can sell your bonds AT a HIGH point. Got that? Let me give you a real example:

   Let’s say you bought your bond (or bond mutual fund) when it is yielding at 5%. So if you put $100, you should get $5 back as interest every year.
   Now, because of Federal Reserve’s interest rate policy, the newly issued bonds that are coming out are yielding at 2.5% instead. Now, if a new guy who invest $100, they will only get $2.5 as interest. Let’s assume that your bond has exactly the same quality/maturity as before (actually the time to maturity will change), it should be yielding at 2.5% also. What does that mean? Now because you are still getting $5 interest on your original investment of $100, at the prevailing interest rate of 2.5%, your bond will actually be valued at $200 because 2.5% of $200 is $5 interest.

   Wow!! You just doubled your money. Isn’t that great? Better than stocks, huh? Now imagine that if interest rate goes from 2.5% to 5%, you would have lost 50% of your money in case you decide to sell. Despite the fact that interest rates change very slowly, bond investing is NOT without risk. This risk of losing money in your principal can be totally eliminated when you invest in actual bonds, instead of bond mutual funds (see the how-to post in this series) but it will take TIME.

2. Time to Maturity:

   This determines when the principal of bonds will be repaid. The longer to the maturity it is, the higher interest yield you should be compensated (with the assumption that the yield curve is not inverted, see below).

3. Yield Curve:

   When you plot the yields of short term bonds to the long term bonds against their time to maturity, it’s called the yield curve (click to see Wikipedia’s explanation). The yield curve is one of the most important tools for macro-economic analysis. When the yield curve is inverted (the long term bonds have less yield than short term bonds), it almost always indicates an economic recession in the near horizon. I don’t have the exact numbers, but I think it’s prediction power is higher than 90%, extremely high for any economic theories. Here is an article from FinancialSense that studies the yield curve and recession. Just pause and think that why in the world will someone invest in 30-year bonds for less yields than 10-year or even 1-year bond for that matter? The only plausible reason is that the shorter term bonds are too good to be true and can only last for 1 year or 10 year, or whatever terms for that particular bond. Well, of course, all the yields are true yields (instead of too good to be true), except that they only last as long as their term. In such cases, often it is caused by central banks to control the economic growth to a more sustainable rate.

4. Credit rating:

   The best ratings of AAA are for US treasury bonds, or GSE (including Fannie Mae and Freddie Mac) bonds. The biggest corporate companies such as GE have pretty good credit ratings too. Then there is municipal bonds that may or may not have good credit ratings. Here is the credit ratings from Moody’s site. S&P also has its set of credit ratings (which you need to register & login to see).

5. Is the interest taxable, and how is it taxed?

   Municipal bonds are usually both state tax-free, and federal tax-free. US treasury bonds are only state tax-free. If you don’t have any state taxes to pay, this tax benefit does not matter to you. Since you still need to pay federal taxes on bonds, the exists a bond called series EE saving bond which allows you to pay taxes on all the interests only at the end of redeeming the bond. Some people like to use this to their tax advantage when buying EE saving bonds for their child who has a lower tax bracket, and won’t need to pay kiddie tax after age of 14.

6. Is it callable?

   Callable bonds allow the issuer of the bonds to repay the debt before maturity. This kind of bond, the issuers may give you a better up-front interest rate, but once the issuers find a cheaper way to refinance their debt, they will do so, and immediately pay you off on the bonds that you bought. Therefore, the expected length to maturity can be much shorter in reality. Do NOT price such bonds at their time to maturity with the assumption that the bonds will not be repaid earlier.

Here are all the posts in the same bond investing series:

1. Intro to Investing in Bonds: Fundamentals
2. Intro to Investing in Bonds: How-to
3. Intro to Investing in Bonds: Risk Factors
4. Reasons for (Not) Investing in Bonds

Money mainly serves two purpose.  It serves as

1. a medium of exchange, and
2. a storage of wealth for one’s past labor.

Understanding what money is, especially the paper money in modern days, is extremely important for preserving one’s own wealth.  If you don’t know how paper money is created or destroyed, you can save money all your life without knowing what exactly you are saving.  And you may not know how your saving can be “stolen” without your permission, or without any decrease in the saving account balance.  Paper money is an electronic record, without much real asset to back it up, except a “full faith in the (US) government”, or faith of “in God we trust”.  Modern monetary system is all about paper money, inflation, and federal reserve system.

Inflation is the debasement of paper money.  Increase in money supply inevitably always leads to inflation, or a higher price of goods & services.  Inflation erodes the purchasing power of your money.  Therefore, it’s important to keep your money in assets that can track inflation.  Every economic cycle has different assets that get inflated. Usually it’s hard to know what kind of assets will get inflated.  Therefore, you should keep your assets diversified according to the distribution of the GDP of the (global) economy, or you can use stock index mutual funds or ETFs to approximate the distribution.  However, on a few occasions, it may be obvious that certain class of assets should be avoided or increasingly allocated.  Under such time, you may want to shift your asset allocation to take advantage of such advanced recognition.

How is money created or destroyed?  The process of money creation is mainly controlled by Federal Reserve System or the central bank of a particular country.  Through a fractional reserve system and purchase or sale of government debt securities (such as treasury bills), the central bank can create and increase money in circulation many folds.  For example, when US federal reserve operates in the open market, and buys US treasury bonds, it is like the left hand (US government) has issued some IOUs into the system, and the right hand (federal reserve) buys it right back by phantom money that didn’t exist before.  What is the end result of such operation?  The executive branch of the US government gets to spend all the money proceeds from the IOU bond, while the federal reserve simply enters in its electronic record that US government owes federal reserve such and such amount from this IOU that is just issued.  In effect, US government dilutes the value of all the existing US dollars by spending the money that didn’t exist before, and take resources away from other US dollar holders.

The same thing is true with all the money in the “lock box” of the US social security funds.  It’s definitely an empty lock box with lines of electronic records.  The left hand, executive branch of the government, print an IOU, gives it to the right hand (social security agency) which then places the IOU in the lock box as if it is worth anything.  Yes, the treasury bonds are a stable investment unlike stocks, and earns some stable interests.  But when the two parties of the IOU (I owe you), are the left and right hands of the SAME person (US government), what good is that IOM (I owe myself)?  You can’t possibly tell me with a straight face, that right after you spend all the social security taxes that are collected every year, you have also invested those social security surplus in a very good stable investment of IOM, right?

I won’t elaborate further, but instead, I want to point you to a few excellent articles on what money is.  They contain much more details than what I can present here:

1. Nature of the Money from Jim Puplava, detailed with historical references.
2. Five Things that You Need to Know About the Dollar from Minyanville.  Short and pithy article.
3. My own article on Inflation.

Master Limited Partnership or MLP is one of my favorite investments to replace bonds.  Obviously, nothing is “safer” than bonds, but the deceiving safety is really a wealth erosion in disguise (through inflation).

So what is MLP?  MLPs are limited partnerships, but trades like all other stocks.  Due to its partnership structure, an MLP usually doesn’t pay income taxes.  The  holders of partnership usually will get regular cash distribution out of partnership, almost like a dividend payment, except that you don’t pay any dividend taxes on it.  The yields on MLP usually range from 6% to 9%, and the cash distribution grows about 5% annually, which is higher than utilities companies.  Over the past ten years, MLPs have delivered above-average returns of 16.1% versus S&P 500 return of 9.9%.  Not only that, MLP stocks are less volatile, and allows investors to participate in the energy sector with much lower risk.

The biggest hurdle for individual investors is the complexity of filing taxes on schedule K-1 which comes with these MLPs.  The forms involved are schedule B, E, Form 8271 Investor Reporting of Tax Shelter Registration Number, etc.  I used TurboTax to help me fill in all kinds of weird numbers in various forms, but as far as I know, Turbo Tax (2004 version) has a bug in calculating your accumulated capital gain/loss when you sell.  You will end up paying a lot more taxes because it doesn’t account for box 1 in schedule K-1.  I have emailed TurboTax 4 times, and called them 1 time, and I have basically given up on TurboTax.  What normally happens in schedule K-1 (if you don’t sell) is that you only pay taxes on tiny amounts of interest & dividends from the MLP, but nothing on the cash distribution which is really the real MLP yield.  At that time of sale, you will adjust your basis with all accounted interest/dividends and cash distribution, and all the gain will become a capital gain.  If it’s long term, it can be taxed at the lower rate (even after dividend tax cut is repealed).  And you can always choose not to sell until death, in which case, you will have a totally tax-free cash distribution for life, with cost-basis stepped-up at death for your heirs without incurring any capital gain taxes.  That is (close to) zero tax for you & your heirs, with current income.

I have invested in more than 5 MLPs in the past, and the returns are terrific.  The best ones are GTM which got bought out by EPD, and KPP which got bought out by VLI.  I have sold out most of my MLPs, except MMP which has one of the higher growth rate in cash distribution.  My primary reason of selling out MLPs is because of the rising yield of 10-year treasury bond which is competing very closely to MLP yields now.  However, to my surprises, MLPs mostly have not gone down much.  It appears that many other positive factors are working for MLPs (as described in my links at the bottom), all resulting in shrinking of the spread of yield premium over treasury bonds.

Here are the two best (and free) articles from Wachovia Securities on MLP.  If you consider investing in MLP, you should definitely read those 40+ pages in the 2nd Edition.  Not a single page will waste your time.

1. Master Limited Partnerships: A Primer
2. Master Limited Partnerships: Primer 2nd Edition

By the way, if you invest MLP in an IRA account, there is a UBTI (Unrelated Business Taxable Income) limit of $1000.  Just be mindful of not hitting that limit.