Better Buy For Retiring With Dividends In April 2024: MLPs Or Yieldcos
Retiring with dividends is a great way to approach one’s golden years because this strategy frees you from concerns about a potential sequence of returns risk. When living off dividend passive income, you never have to sell stocks during a bear market to fund living expenses; instead, you can sit back, relax, and live off the passive income from your dividends.
However, when building a dividend portfolio to fund retirement, it is imperative to insist on high-quality stocks. Otherwise, your holdings may let you down when times get tough. A dividend stock for retirement should have at least the following four qualities:
First, they should come from durable and defensive business models, so you don’t have to worry about technological disruption or severe economic downturns threatening the sustainability of a dividend. Moreover, the company should have a very strong balance sheet, so management is never faced with the choice between reducing your dividend check or saving its balance sheet from a credit rating downgrade.
Third, the dividend should be completely covered by cash flow to ensure that short-term volatility in cash flows will never threaten the dividend. Furthermore, a company that can retain earnings is more likely to sustain a strong balance sheet over time and also maintain its durable competitive positioning by being able to reinvest in the business to innovate and maintain a strategic position in core business segments. Last but not least, this extra cash flow ensures that the company should be able to grow its earnings over time, thereby enabling it to grow its dividend payout at a pace that ideally matches or even exceeds inflation. This will protect your passive income stream’s purchasing power over the long term, which is essential if you’re planning to live off dividends for decades to come.
Fourth, dividend stocks should pay a high enough current yield to ensure that your portfolio can generate enough passive income to support your living expenses today. Combining the sustainability and growth aspects discussed in the first three points ensures that you can live well today, tomorrow, and decades into the future off your dividend income stream.
As I discussed in my recent article My Favorite Sectors To Find Dividend Stocks In April 2024, some of the most popular sectors for investors to search for dividend stocks that meet these four qualities are the midstream MLP space (AMLP) as well as the renewable power yieldco space. In this article, we will compare them head-to-head to see which is a better buy for retiring on dividends in April 2024.
Why Retirees Love Midstream MLPs
Before we jump into discussing these two types of businesses, let’s first discuss why they are so popular with retirees. MLPs are popular with income-focused retirees because, first of all, they typically pay out very attractive distribution yields that range from the high single digits to even the low double digits. Secondly, the sector has gone through a transition over the past half-decade where MLP management teams have focused heavily on rapidly deleveraging their balance sheets and cutting capital expenditures in order to high-grade their organic growth investments and maximize their free cash flow generation. As a result, they are now in a very strong financial position in most cases and are also looking to accelerate their capital returns to unit holders.
Furthermore, these businesses offer tax-advantaged distributions, which – though they often come with the dreaded K-1 tax form – also come with the benefit of the vast majority of distributions being treated as a return of capital, which creates deferred taxes on these distributions and potentially completely tax-free income if the MLP is held until the unit holder dies, at which point the units are passed on to heirs at a stepped-up cost basis.
Finally, the sector is quite defensive and durable, given that the cash flows are generated by heavily contracted, in some cases regulated, assets to mostly creditworthy counterparties, providing essential services for an industry and energy sector that is unlikely to go anywhere soon. Moreover, energy tends to serve as an excellent inflation hedge, making this sector a good place to invest when elevated inflation is expected. The strong outperformance of the sector in recent years during a high inflation environment serves as a testament to that fact, as the distributions are very well covered by cash flows in most cases, with a typical coverage ratio ranging from 1.5 to 2 times among the most popular midstreams such as Energy Transfer (ET), MPLX (MPLX), and Enbridge (ENB), making it a very safe and secure source of lucrative passive income for years to come.
Why Retirees Love Renewable Yieldcos
Yieldcos are also popular with retirees for many of the same reasons as MLPs are. They invest mostly in renewable power production assets such as solar farms and wind farms, which are highly contracted to investment-grade utilities in most cases, with power purchase agreements often lasting up to 20 or even 25 years. Some of these power purchase agreements are even indexed to inflation, adding additional cash flow security for investors in all sorts of investment environments. As a result, investors can count on a steady stream of cash flows to support hefty distribution payouts.
Additionally, due to the real asset nature of these portfolios, much, if not all, of their distributions are treated as a return of capital, creating similar tax benefits to what MLPs enjoy without the K-1 headache in most cases. Moreover, the renewable power sector enjoys high degrees of government support along with a robust growth runway for decades to come, making them potentially very attractive growth stocks in addition to the high yields that they currently provide.
Midstream MLPs Vs. Renewable Yieldcos
While MLPs and renewable power yieldcos have many similar traits, there are three big differences between them at the moment.
The biggest difference is that MLPs are much better suited to a higher-for-longer environment due to their having much stronger balance sheets and being less dependent on accessing capital markets to sustain their business models. This is because most of them retain enormous amounts of cash flow that they can use to pay down debt, fully fund distributions, and their growth investments. In contrast, renewable power yieldcos are rarely investment-grade and therefore have a higher cost of debt and also, in some cases, need to raise equity in order to fund investments.
Another big difference is that many midstream pipelines are protected from competition due to regulatory and political opposition to new pipeline construction, giving them longer shelf lives and strong moats and in highly strategic areas, even the possibility to appreciate over time. In contrast, renewable power assets like windmills and solar farms depreciate over time, requiring additional investment to replace their productive capacity in the future. That being said, repowering projects tend to have very high returns for renewable yieldcos, so this is not as huge of a problem for the sector as it might first seem.
The last big difference is that while they have much greater risk due to their capital markets exposure in a high-rate environment, yieldcos offer much higher long-term total return potential due to the fact that they currently offer distribution yields that are on par or even higher in many cases than their midstream counterparts, and also have much stronger growth potential due to the projected strong demand growth for renewable power. In contrast, pipeline companies have fewer and fewer attractive growth investment opportunities in front of them due to regulatory headwinds and are therefore relying increasingly on unit repurchases and industry consolidation to drive growth.
Investor Takeaway
While I like both sectors and am invested heavily in both of them. I think yieldcos are generally better suited to more aggressive, total return-oriented investors, whereas midstream MLPs are generally better suited towards more conservative, income-oriented retirees due to their lower balance sheet risk and more secure distributions. As a total return-oriented investor who also values generating attractive current income, I think it’s important to maintain diversification in both sectors.
Some of my favorite picks of the moment are Enterprise Products Partners (EPD) and Kinder Morgan (KMI) in the midstream sector, while some of my favorite renewable yieldcos at the moment are Brookfield Renewable Partners (BEP)(BEPC) and Clearway Energy (CWEN)(CWEN.A). Enterprise Products Partners and Kinder Morgan both offer very attractive current yields and have strong balance sheets and high-quality assets, while still having decent single-digit annualized growth potential. Brookfield Renewable and Clearway Energy offer high single-digit yields while also offering high single-digit to low teen annualized growth potential. BEP is particularly attractive right now due to the fact that it has a BBB+ credit rating and a very well-laddered debt maturity profile along with significant inflation indexation, making it a much lower risk investment in a higher-for-longer environment than most of its renewable yieldco peers.