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Corporate bonds

MLP bonds: Attractive coupon "stream" update | 16 August 2017

Chief Investment Office Americas, Wealth Management Barry McAlinden, CFA, Senior Fixed Income Strategist Americas, barry.mcalinden@; James Dobson, MLP and Utilities Equity Sector Strategist Americas, james.dobson@; Daniel Kelsh, Senior Fixed Income Strategist Americas, daniel.kelsh@

? MLP debt has been a strong segment of the IG market when performance is measured on a YTD basis but this segment has underperformed since we launched the theme in late February.

? MLP bond spreads remain at about the same level as when we launched the theme, while IG index spreads have compressed by 8bps. At a 50bps advantage, MLP bond spreads have only been wider than the IG index about 20% of the time over the past twenty years.

? We believe that an improvement in fundamentals and more stable oil prices should lead to better performance. We make no change to the highlighted bonds as we believe these issuers offer attractive yields and solid fundamentals.

Theme recap

We launched the fixed income theme "MLP bonds, Attractive coupon stream" at the end of February, as we identified this sector as offering attractive coupon income in an environment where IG credit spreads are expected to trade sideways. The average credit quality of the pipeline segment is rated BBB, fitting the "down in quality bias" trend that should occur as stronger economy and prorisk environment should favor lower rated issuers. We also viewed the fundamental profile of the MLP (midstream) sector favorably due to the fee based nature of their businesses and the fact that many issuers have been improving their balance sheets in an effort to maintain IG ratings. For example, when Plains All American (not on our list) recently announced another cut to their distribution, they cited a commitment to maintaining a strong capital structure and investment grade credit ratings.

After having been overly aggressive in the lead up to the commodity price downturn, midstream energy companies are generally employing more conservative financing policies. This includes reducing leverage and improving distribution coverage. To implement the theme, we highlight the bonds of five midstream issuers that screen well as offering both attractive yields and solid fundamentals.

Bad timing on theme launch The basket of bonds that we use to measure the theme's performance has underperformed its benchmark (IG index) by 100bps since we launched the theme on 23 February. When measured from the beginning of the year, however, these bonds have outperformed the IG index by 29bps. MLP debt benefited

A version of this report is available with specific security recommendations for the US onshore investors. For a copy, please consult your UBS Financial Advisor

Fig. 1: BBB bonds outperforming YTD Excess return relative to government bonds, in %

3.0

2.5 2.4

2.0 1.6

1.5

1.0

2.3 1.0

2.1 1.0

1.8 1.3

1.4 1.1

0.5

0.0 IG BBB-rated IG MLP Excess return YTD

IG Energy IG index IG A-rated Excess return since 23 February

Source: BAML, UBS, as of 14 August 2017 Fig. 2: MLP bonds underperforming IG index since late February theme launch Total return since 23 February, in %

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0

-3.0 Feb-17

Mar-17

Apr-17

May-17

MLP bond list

Jun-17 IG index

Jul-17

Aug-17

Source: Bloomberg, UBS, as of 14 August 2017

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 3.

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from the optimism that was prevalent early in the year that Trump's policies could include an infrastructure component. Hopes have since faded that the Trump administration will be able to push through tax cuts or higher infrastructure spending anytime soon.

Another factor that contributed to the theme's relative underperformance has been the high correlation that MLP bond credit spreads have exhibited with oil prices. WTI was trading around USD 55 at the time of the theme's launch and declined to a low of USD 43 in late June. Even with the recovery, prices remain over 10% below beginning of year values. This stems from the slow pace of global inventory declines that have been witnessed along with concerns on rising US production. These are factors which CIO deems to be transitory but nonetheless the market may remain skeptical on the pace of rebalancing, which could weigh on sentiment.

The correlation between MLP credit spreads and oil has been high but this stems largely from the indirect exposure that midstream partnerships have to commodity producers. When compared to IG energy producers, MLP bonds exhibited lower sensitivity to oil prices during the peak of the oil stress from late 2014 to early 2016. Many of the contracts that midstream partnerships engage in are fee based but lower oil prices can raise concerns over the ability of counterparties to meet the terms of their contracts. To the extent that midstream companies continue to strengthen their balance sheets to be better prepared for a downside scenario, this should help lessen the correlation that MLP bonds have with oil prices, in our view.

Theme drivers still hold Midstream issuers as a whole have been improving their credit profiles by reducing leverage and improving distribution coverage with strong incentive to maintain investment grade ratings. These more conservative financial policies are being adopted at a time when business conditions for midstream companies are improving. Increasing crude oil and natural gas production activity, particularly in the Permian and the Marcellus shale formations, as well as growing demand for natural gas and natural gas liquids in the US, will likely drive the need for additional energy infrastructure expansion over the next several years.

From a valuation standpoint, IG MLP bond spreads are currently at 166bps, which is roughly the same level as when the theme was launched. IG index spreads have tightened 8bps since late February, which has increased the spread advantage that IG MLP bonds have over the IG index to 50bps. MLP bond spreads have only been wider than the IG index about 20% of the time over the past twenty years.

When compared to oil & gas companies (147bps), IG MLP bonds remain about 20bps wider which is the same differential as when we launched the theme and this in line with historical averages. Combining the improving fundamentals and the attractive credit spreads leaves MLPs well-positioned looking forward, in our view. In addition, without much policy success being priced into MLP debt, this leaves room for upside should progress on the infrastructure side of the agenda gain momentum next year. CIO's outlook on oil prices also remains constructive as the rebalancing in the global oil markets should support higher oil prices.

Fig. 3: Theme's relative performance has been correlated with oil prices Relative return (LHS), in % and WTI oil price (RHS), in USD

0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.2 -1.4 -1.6

Feb-17

Mar-17

Apr-17 May-17

Jun-17

Jul-17

56 54 52 50 48 46 44 42 40 Aug-17

Relative performance (LHS)

WTI oil price (RHS)

Source: Bloomberg, UBS, as of 14 August 2017

Fig. 4: Fundamentals for MLP debt issuers are improving Leverage and interest coverage ratios

6

5

4

3

2

1

0

CY2013

CY2014

CY2015

CY2016

LTM

Debt/EBITDA EBITDA / Interest Exp.

Source: S&P Capital IQ, UBS, as of 2Q17 LTM. Chart shows aggregated metrics from thirteen IG MLP issuers with the most debt outstanding

Fig. 5: MLP bond spreads have widened vs. the IG index Spread, in bps

60

50

40

30

20

10

0 Jan-17

Mar-17

May-17

IG MLP less IG Oil & Gas

Jul-17

Sep-17

IG MLP less IG Index

Source: BAML, UBS, as of 14 August 2017

UBS Chief Investment Office Americas, Wealth Management 16 August 2017 2

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Appendix

Disclaimer

Research publications from Chief Investment Office Americas, Wealth Management, formerly known as CIO Wealth Management Research, are published by UBS Wealth Management and UBS Wealth Management Americas, Business Divisions of UBS AG or an affiliate thereof (collectively, UBS). In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS). All information and opinions as well as any prices indicated are current only as of the dateof this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to thoseexpressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS and its employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law. Distributed to US persons by UBS Financial Services Inc. or UBS Securities LLC, subsidiaries of UBS AG. UBS Switzerland AG, UBS Deutschland AG, UBS Bank, S.A., UBS Brasil Administradora de Valores Mobiliarios Ltda, UBS Asesores Mexico, S.A. de C.V., UBS Securities Japan Co., Ltd, UBS Wealth Management Israel Ltd and UBS Menkul Degerler AS are affiliates of UBS AG. UBS Financial Services Incorporated of Puerto Rico is a subsidiary of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS Financial Services Inc. is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. Version as per May 2017. ? UBS 2017. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

UBS Chief Investment Office Americas, Wealth Management 16 August 2017 3

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