Currently, while the interest rates are relatively high, it is still possible for retirement investors to lock in defensive and meaningful dividend yields.
It is rather clear that the odds are very high that from here the interest rates will go only down. The question, of course, remains open as to how deep the forthcoming cuts will be and where the Fed will find the equilibrium. For example, if the Fed cuts circa 100 basis points and stops there for a long period of time, that would not be that bad for income investors as the yields in that case would remain at somewhat acceptable levels (i.e., at least in much more acceptable territory than during the ultra-low interest rate environment).
However, the fact is still quite clear that the yields we are seeing now will most probably not be here for long. Since for most retirement income investors yields are important and especially if they come along with sufficient margin of safety and stability, the current moment is the one to put the capital at work.
Higher interest rates have not only pushed bond and junk fixed income yields higher, but also they have made many high-quality equities more attractive for conservative retirement income investors. Even in some cases it is possible to find blue-chip names that exhibit truly defensive financial characteristics and offer dividend yields that are higher than the one provided by high yield single B U.S. bonds (i.e., ICE BofA Single-B US High Yield Index Effective Yield indicates 6.8% effective yield).
To put it differently, through some specific cherry-picking retirement income investors can access assets that meet the fundamental criteria of a sound retirement investment:
- Yield that is attractive and greatly exceeds inflation already from start.
- Yield that is subject to steady growth to offset inflation dynamic.
- Yield that is underpinned by robust cash flow generation.
- Yield that is supported by well-capitalized balance sheet.
With this in mine, let me provide you with two specific picks that tick all of the aforementioned boxes (criteria), while offering high yield than that of Single-B US High Yield Index.
#1 Main Street Capital (MAIN)
MAIN is one of the largest BDCs with a NAV base of ~ $2.6 billion, carrying arguably the most conservative fundamentals in the entire BDC space. Part of this could also be implied directly from the P/NAV, which stands at 1.6x – i.e., the highest statistic in the sector. Yet, even though the premium is notable, the FWD annualized dividend yield is fairly attractive – at ~ 8.4%.
Here one might make a case that MAIN is a bad investment because of the significant premium over NAV. It could agree with that if the objective was to capture and focus on price appreciation in the short to medium-term. However, given that we are talking about defensive retirement yield-driven strategy, what matters most is that the entry dividend is protected and subject to sustainable growth.
Looking at the key fundamental metrics, we can clearly see that it is the case.
For example, MAIN has one of the strongest investment portfolios from the credit metric (or risk) perspective.
The lower middle market portfolio, which is the largest earnings driver for MAIN has the following credit statistics:
- Senior leverage of 2.8x EBITDA.
- Total leverage of 2.9x EBITDA (including junior debt).
- 2.4x EBITDA to senior interest coverage.
It would be really tough to find a BDC that would exhibit comparable portfolio quality characteristics. Personally, by actively covering many names within the BDC segment, I have not found a BDC, which has so strong leverage metrics in combination with interest coverage above 2.1x.
Plus, given that MAIN so large, it can also enjoy a diversification benefit, where for example the largest position in its LLM segment accounts for less than 1% of the portfolio fair value.
On top of that, MAIN usually incorporates an equity injection component when providing debt financing to high-quality businesses. Since these proceeds are invested in defensive companies that already generate solid levels of cash, the probability for MAIN to realize a positive value from potential exits is high. For example, as of Q2, 2024 MAIN had circa $6.00 per share in cumulative, pre-tax net unrealized appreciation (i.e., 12% of current market cap and sufficient to cover ~ 1.5 years of dividend just from the implied equity monetization proceeds).
For retirement income seeking investors this means that MAIN can periodically harvest part of these gains that in turn would complement the recurring interest income streams, which currently warrant a base dividend coverage of ~ 140%.
Finally, MAIN has a strong leverage profile of 0.85x, which is considerably below the sector average of 1.16x. This introduces an extra protection for the current cash flows, while offering a space for further portfolio growth without assuming elevated financial risk.
#2 Plains All American Pipeline (PAA)
Plains All American is a medium size MLP with a market cap of $12.2 billion. Just as most of its peers, PAA owns and operates midstream energy infrastructure, focusing on pipeline transportation and storage of crude oil and NGL.
The case with PAA is similar to that of MAIN, where the current yield is attractive (above single B high yield index), the cash flows are strong, and the capital structure is in a great shape.
Let me now explain why, in my view, PAA’s current yield of ~ 7.3% could be deemed very enticing from the defensive retirement income perspective (albeit keep in mind that PAA is subject to K-1).
The beauty of PAA’s business is that it is backed by long-term and bankable offtake agreement that provide the necessary stability and predictability for the underlying cash generation (i.e., pre-stipulated price mechanism and minimum volume guarantees). Most of these contracts are also linked to periodic revenue escalators, which help grow the business also from the organic front.
However, the key essence here lies in the combination of healthy CapEx levels, optimal capital structure and huge distribution coverage.
For example, based on Q2, 2024 earnings data points, the expected adjusted free cash flow level for 2024 is at $1.55 billion, which includes $130 million of M&A and $1.15 billion of distributions to common and preferred unit holders.
Meanwhile, if we look at the balance sheet we will see that there is little room for further debt reduction since the current PAA’s leverage of 3.1x is already below its target range of 3.25x to 3.75x.
Given the dividend distribution coverage of 190%, balanced CapEx ambition and no need to de-risk the balance sheet, investors can expect sizeable increases in the current dividend.
The comment in Q4, 2023 earnings call by Al Swanson – Executive Vice President & Chief Financial Officer – clearly confirmed this:
Well, I think, our current guidance for this year shows 190% coverage. So, we’ve got a bit to go our stated approach will be $0.15 a year until we hit the 160%. And then DCF growth will drive future increases there. So, we haven’t provided guidance for ‘25 or ‘26 yet. But yes, with this 19% or 20% increase we just did, we’re still at 190% coverage.
Moreover, the recent quarterly results indicate that PAA enjoys additional tailwinds from growing business, where the Q2, 2024 EBITDA came in ~ 13% above the result achieved in the same period last year.
The bottom line
When selecting securities for a retirement income portfolio, there are multiple criteria that have to be fulfilled in order to secure stability and predictability, especially if a particular investment offers high dividends.
Since the current interest rates before they get decreased still offer a favorable environment for high yield investors to lock in acceptable dividends at low risk, it is worth for conservative retirement investors to consider an active deployment of capital.
In this article, I have elaborated on two securities – MAIN and PAA – that embody the necessary defensive characteristics, while offering dividends that are above high yield index.
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