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 quite strong. In this article, we will share a simple portfolio designed to generate a 7.8% dividend yield along with solid dividend growth while also avoiding taxes at the individual and corporate level.
The way we accomplish this is by investing in three business development companies (BIZD), three midstream MLPs (AMLP), and three real estate investment trusts (VNQ) as all of these corporate structures are exempt from paying corporate income tax as pass-through entities. By placing the REITs and BDCs in a Roth account and the MLPs in a taxable account and holding them until death, you get the benefits of not having to pay any taxes on dividends. This is because the MLP distributions are almost always considered to be return of capital, which means they are tax-deferred, and if you hold the MLPs until you die, you can pass them on to your heirs with a cost basis step-up, effectively rendering the distributions you have received in the meantime completely tax-free. Additionally, even if you live long enough for your return on capital to deplete your cost basis, by simply reinvesting some of your distributions in buying more of those same MLPs, you can increase your cost basis again, thereby continuing to defer paying taxes indefinitely. Note that this is not tax advice, as it merely reflects my own understanding of how things work, but I am not a tax expert.
Without further ado, let's discuss the nine stocks.
BDCs
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% next 12-month dividend yield, they cover their dividend quite comfortably with net investment income, and they have strong underwriting performance with just 0.4% of the portfolio at cost on non-accrual, and 98.4% of the portfolio has an internal risk rating of either one or two. Additionally, 95% of the portfolio is invested in first-lien loans and 4% in second-lien loans, leaving a mere 1% in non-first or second-lien loans. On top of that, 94% of its portfolio is considered non-cyclical, and its net leverage ratio is very low at 0.77 times earnings, with an investment-grade credit rating. With such strong numbers behind it, and especially considering the fact that it trades at a very low premium to its net asset value at a time when its blue-chip peers like Hercules Capital (HTGC) and Main Street Capital (MAIN) trade at much larger premiums to NAV, MSDL makes for a great income stock for investors who want to be in business development companies right now but don't want to take on too much risk.
Meanwhile, OBDE has a 9.3% expected next 12-month total dividend yield, a leverage ratio of around 1, and 95.3% of its portfolio invested in debt, including 88.8% in first and second lien loans. It also has an investment-grade credit rating and trades at a 4.22% discount to NAV, making it one of the most attractive risk-adjusted BDC investment opportunities right now.
Last but not least, BXSL - despite trading at a fairly steep premium of 19.27%, and therefore I would not recommend buying it for someone concerned about total returns - offers a very attractive next 12-month dividend yield of 9.9% that is well covered by net investment income. This should be safe for the foreseeable future, especially because 98% of its portfolio is invested in debt, and 97.6% of the portfolio is in first or second-lien debt, with virtually all of that in first-lien loans, making it a very conservative portfolio. This is especially the case given that it is backed by Blackstone (BX), which is the largest alternative asset manager in the world.
MLPs
The midstreams that I would hold right now 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 3 times leverage ratio. Its 7.4% distribution yield is very attractive and is covered about 1.7 times by distributable cash flow, and it is also growing its distribution at about a 5% CAGR, which is backed by similar distributable cash flow per unit growth. With its significant growth pipeline set to come online in the next few years, its leverage ratio is likely to drop even further, paving the way for even faster distribution growth and/or significant unit repurchases. Additionally, its portfolio is very well diversified and earns a wide moat rating from Morningstar.
I also like Energy Transfer right now because it has an attractive 7.9% distribution yield that's covered about 1.9 times by distributable cash flow. It is also growing its distribution at a 3-5% CAGR and has an investment-grade BBB credit rating. It is also pursuing attractive growth investments while recently redeeming a large number of its preferred units, which further strengthens its balance sheet and its common distribution safety. It will be interesting to see what it does next with the significant amount of excess cash flow that it generates, potentially opting for unit repurchases or faster distribution growth unless it decides to make a big acquisition.
MPLX rounds out the group with a very strong track record of growing its distribution, currently yielding 8.4% on a next 12-month basis. Like Energy Transfer, it also has a BBB credit rating and comfortably covers its distribution. It has some solid growth investment projects underway that should continue to drive mid-single-digit distribution growth per year moving forward.
REITs
The three REITs that I like right now for a retirement income portfolio are W.P. Carey (WPC), Realty Income (O), and Mid-America Apartment Communities (MAA). While these may not be my three favorite REITs from a total return perspective, I like them a lot from a yield and safety perspective.
WPC has a 6.3% next 12-month dividend yield, trades at a discount to its net asset value, has a BBB+ credit rating, and recently exited the office sector. With a growing portfolio of quality industrial and warehouse properties and the majority of its rent comes from CPI-linked leases, it is uniquely well-positioned to weather periods of stagflation even if interest rates remain higher for longer.
O does not have the significant CPI-linked exposure that WP Carey has, but it has an A- credit rating, arguably the best long-term track record of any major REIT, a 6% forward dividend yield that is 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 REIT that has a pristine balance sheet and an impressive long-term track record of generating attractive total returns and dividend growth. It offers a 4.3% next 12-month dividend yield and trades at a 9% discount to its net asset value. Putting that all together, MAA looks like an attractive way to diversify the portfolio into a defensive sector that also has attractive growth dynamics over the long term.
Investor Takeaway
Keep in mind, as you can see from these nine selections, they are not all optimized for maximizing total returns, but the aggregate total return potential is still pretty solid. This is particularly true when you consider the starting yield for the next 12 months projected for the entire portfolio, assuming an equally weighted holding of each, is 7.8%. Meanwhile, the REITs and MLPs in this portfolio should be expected to grow on a weighted average of about 5% per year. The BDCs will likely grow at most 2% per year on average, though this will be choppy given that their kind of investment performance rises and falls with interest rates. Even if there is no growth from those holdings, in aggregate the dividends should grow at around a 3% annualized pace, which should be in line with long-term inflation levels.
It is also worth noting that the portfolio benefits from nice diversification. For one, it is very defensive in nature, so it should hold up fairly well during economic downturns. Additionally, triple net lease REITs tend to do best when interest rates fall, the BDCs will do better when interest rates rise, and the MLPs are more of an inflation hedge, given that energy tends to do best in high inflation environments, and - with their strong balance sheets and relatively internally funded growth investments - they are largely agnostic to where interest rates go, especially over short periods of time.