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Benjamin Franklin is credited with saying, “In this world nothing is certain except death and taxes.” As many investors approach retirement, they become increasingly aware of the certainty of death. However, the motivation to avoid painful taxes also becomes very strong. In this article, we’ll share a simple portfolio designed to generate a 7.8% dividend yield and solid dividend growth while avoiding taxes at the individual and corporate levels.
We do this by investing in three business development companies (BIZDs), three pass-through MLPs (AMLPs), and three real estate investment trusts (VNQs), as all of these business structures are exempt from corporate tax as pass-through entities. By placing the REITs and BDCs in a Roth account and the MLPs in a taxable account, By holding them until you die, you get the benefit of not having to pay taxes on the dividends. That’s because MLP distributions are almost always considered a return of capital, meaning they are tax-deferred, and if you hold the MLPs until you die, you can pass them on to your heirs at a step-up in cost, effectively making the distributions you received in the meantime completely tax-free. Additionally, even if you live long enough for your capital return to deplete your cost, by simply reinvesting a portion of your distributions into buying more of those same MLPs, you can increase your cost again, continuing to defer paying taxes indefinitely. Note that this is not tax advice, as it simply reflects my own understanding of how things work, but I am not a tax expert.
Without further ado, let’s discuss the nine actions.
BDC
First, the BDCs include Morgan Stanley Direct Lending Fund (MSDL), Blue Owl Corporation III (OBDE), and Blackstone Secured Lending Fund (BXSL). I recently wrote a more in-depth article on MSDL, but the bottom line is that they offer a very attractive 10.5% dividend yield over the next 12 months, they cover their dividend quite comfortably with net investment income, and they have strong underwriting performance with only 0.4% of the portfolio at cost on non-accrual loans, and 98.4% of the portfolio has an internal risk rating of 1 or 2. Additionally, 95% of the portfolio is invested in first-lien loans and 4% in second-lien loans, leaving only 1% in non-first-lien or second-lien loans. Additionally, 94% of its portfolio is considered non-cyclical, and its net debt ratio is very low at 0.77 times earnings, with an investment grade credit rating. With such strong numbers behind it, and especially considering that it is trading at a very small premium to its NAV at a time when its blue-chip peers like Hercules Capital (HTGC) and Main Street Capital (MAIN) are trading at much larger premiums to NAV, MSDL is a great income stock for investors who want to invest in business development companies now, but don’t want to take on too much risk.
OBDE has an expected total dividend yield of 9.3% over the next 12 months, a debt-to-equity ratio of approximately 1x and 95.3% of its portfolio invested in debt, including 88.8% in first and second lien loans. It also benefits from an investment grade credit rating and trades at a 4.22% discount to net asset value, making it one of the most attractive risk-adjusted BDC investment opportunities available today.
Finally, BXSL – while trading at a fairly high premium of 19.27%, and so I wouldn’t recommend it to anyone concerned about total return – offers a very attractive 12-month dividend yield of 9.9%, which is largely covered by net investment income. This should be safe for the foreseeable future, especially as 98% of its portfolio is invested in debt and 97.6% in senior or junior debt, with almost all of that being senior loans, making it a very conservative portfolio. This is especially the case as it is backed by Blackstone (BX), which is the world’s largest alternative asset manager.
MLP
Mid-cap stocks I would currently hold in a retirement income portfolio are Enterprise Products Partners (EPD), Energy Transfer (ET), and MPLX (MPLX).
I like Enterprise Products Partners because it has the strongest balance sheet in the midstream sector, with an A- credit rating and a 3x debt-to-equity ratio. Its 7.4% distribution yield is very attractive and is covered at about 1.7x by distributable cash flow, and it is also growing its distribution at a CAGR of about 5%, supported by similar growth in distributable cash flow per unit. With its significant growth pipeline expected to come online in the coming years, its debt-to-equity ratio should decline further, paving the way for even faster distribution growth and/or significant unit repurchases. Additionally, its portfolio is very well diversified and earns a low-end rating from Morningstar.
I also like Energy Transfer right now because it has an attractive 7.9% distribution yield, which is covered about 1.9 times by distributable cash flow. It is also growing its distribution at a CAGR of 3-5% and has an investment-grade BBB credit rating. It is also looking for attractive growth investments while recently repurchasing a large number of its preferred units, further strengthening its balance sheet and common distribution security. It will be interesting to see what it does next with the significant amount of excess cash flow it is generating, potentially opting for share buybacks or faster distribution growth, unless it decides to make a big acquisition.
MPLX completes the group with a very good track record of distribution growth, with a current yield of 8.4% over the next 12 months. Like Energy Transfer, it also benefits from a BBB credit rating and comfortably covers its distribution. It has solid growth investment projects underway that should continue to generate annual distribution growth of around 10%.
FPI
The three REITs I currently like for a retirement income portfolio are WP Carey (WPC), Realty Income (O), and Mid-America Apartment Communities (MAA). While these three REITs may not be my favorites from a total return perspective, I like them a lot from a yield and safety perspective.
WPC has a 6.3% dividend yield over the next 12 months, trades at a discount to its net asset value, has a BBB+ credit rating and has recently exited the office sector. With a growing portfolio of quality industrial and warehouse properties and the majority of its rents coming from CPI-indexed leases, it is uniquely positioned to withstand periods of stagflation, even if interest rates remain elevated for longer.
It doesn’t have the significant CPI exposure that WP Carey does, but it does have an A- credit rating, arguably the best long-term track record of any large REIT, a 6% forward dividend yield that’s well covered by earnings, and a very large and well-diversified portfolio of quality real estate that positions it very well to weather a recession.
Finally, MAA is a high-quality multifamily real estate investment trust with an impeccable balance sheet and an impressive track record of total returns and long-term dividend growth. It offers a 4.3% dividend yield over the next 12 months and trades at a 9% discount to its net asset value. Considering all of this, MAA appears to be an attractive way to diversify the portfolio in a defensive sector that also has attractive long-term growth dynamics.
Key takeaways for investors
Keep in mind that, as you can see, not all of these nine picks are optimized to maximize total return, but the overall total return potential is still quite solid. This is especially true when you consider that the initial yield over the next 12 months expected for the entire portfolio, assuming equal weighting of each holding, is 7.8%. At the same time, the REITs and MLPs in this portfolio are expected to grow at a weighted average of about 5% per year. The BDCs are likely to grow at an average of 2% per year at most, although this growth will be volatile given that their investment yield rises and falls with interest rates. Even if these holdings do not generate any growth, dividends are expected to grow at an annualized rate of about 3% overall, which should be in line with long-term inflation levels.
It is also worth noting that the portfolio benefits from good diversification. For one, it is very defensive in nature, which should allow it to hold up well in an economic downturn. In addition, triple net lease REITs tend to perform better when interest rates fall, BDCs do better when interest rates rise, and MLPs are more of an inflation hedge, given that the energy sector tends to perform better in high-inflation environments, and – with their strong balance sheets and relatively internally funded growth investments – they are largely insensitive to changes in interest rates, especially over short periods.