Why I buy dividend stocks for my retirement as a millennial

Although I’ve written a lot about high-yield investing covering many value plays, I haven’t gone into a lot of detail about portfolio construction, my investment goals, and my strategy.

So, the aim of this article is to make 3 specific points Aspects that characterize the overall investment allocation process, as we hope some of this sounds interesting and useful in the context of your investment approach:

1. What are the goals?
2. Which asset classes achieve these goals?
3. What is the main risk?

Let us now analyze each of these topics separately.

1. Objectives

The overarching goal is to retire early (within approximately 10 years) before the state pension kicks in without sacrificing living standards and without having to tap into portfolio holdings to fund retirement.

While I live in a European country and I have an official At a job, where consistent contributions are made to a defined benefit plan, I leave potential income streams from this component out of the “retirement” equation. In other words, I consider this a suitable option that could at some point supplement the income streams coming from my core retirement portfolio.

It is also important that retirement income is linked to inflation dynamics so that living standards can be maintained in the long term. Otherwise, income growth is welcome but not as important as maximizing return stability and predictability.

In general, it boils down to determining monthly (or annual) living expenses and building an asset base that produces distributions, which will be sufficient to cover the cost base, while leaving some explicit and implicit margin of safety. With explicit margin of safety, I mean having higher cash inflows than outflows (living expenses), while implicit refers to the following aspects that should be included in a retirement portfolio:

• Dividends, or distributions, are supported by a solid business.
• A conservative cash payout ratio, which leaves some capital for growth and adds an extra layer of security when it comes to dividend stability.
• Strong capital structures.
• • Income can grow over time and/or at least move in line with inflation dynamics.

These above aspects provide a good journey to the next section of specific asset classes that meet the necessary criteria and thus constitute the lion’s share of my retirement portfolio.

2. Asset classes

There are three distinct asset classes, which go hand in hand with the overall objective function of having defensive, progressively growing and material sources of income.

#1 Equity REITs

Equity REITs offer a great mix of return factors, which lend themselves well to dividend or income investing strategies. Equity REITs collectively account for roughly 40% of my retirement portfolio.

As with any sector or asset class, there are good and bad choices out there. For example, investing in office space, the healthcare sector, companies with abnormal leverage profiles or those without investment-grade credit ratings can actually introduce excessive portfolio risk, as some earnings reductions are likely to materialize.

For sound and defensive income investing, investors need to be very selective with REITs. There are three important tools to adhere to if the goal is to tick all the boxes on the implicit margin of safety components outlined above.

First, the cap should be based on long-term lease agreements, which include periodic ladders. Furthermore, the core tenant profile must be diverse and financially sound to avoid the consequences of potential bankruptcies like what we have seen in the retail space.

Second, the capital structure must be very strong and supported by an investment-grade credit rating. The REIT business is all about capturing positive spreads between the cost of capital and real estate returns. The presence of investment grade credit allows for more attractive spreads and/or does not force boards of directors to go too far down the risk curve by sourcing only speculative investment projects to secure accretive spreads.

Third, AFFO payments should be supportive of continued growth in a sustainable manner, while REITs can avoid financing organic growth or mergers and acquisitions only by expanding leverage. Retaining a portion of AFFO at the REIT level also serves as a dividend protection mechanism because in the event of any decline in cash generation, the REIT will not automatically fall into the zone where it has to finance existing dividends from debt or asset sales (i.e. make Dividend cuts are less likely).

REITs like Realty Income Corporation (NYSE:O) (see my article here) and STAG Industrial, Inc. (NYSE:STAG) (see my article here) and EPR Properties (NYSE:EPR) (see my article here) are great examples that fit the necessary criteria.

#2 BDC

BDC is another interesting asset class that pairs well with dividend/income investing strategies. However, unlike equity REITs, on average, BDCs are riskier because their inherent nature revolves around accessing cheap capital and investing in companies that typically struggle to access favorable financing terms from traditional banks. Therefore, defensive investors and retirement-focused investors should be more careful when choosing the right names for stable income investing.

The reason why business development companies are great in this context is that their strategy is to focus primarily on producing stable income streams while keeping rising prices as a secondary goal. In addition, the returns they offer are usually higher than what can be obtained from well-known dividend stocks or even lower than investment-grade fixed income alternatives.

When selecting BDCs that have the right characteristics to absorb attractive profits in a sustainable manner, these are the key financial elements that BDCs must have:

• An investment strategy that is only tied to existing cash flows and a well-established and solid business (i.e. no investments in venture capital type businesses or collateralized loan obligation structures).
• The majority of the portfolio’s investments are concentrated in secured first lien assets.
• High margin of safety when it comes to covering underlying earnings by adjusted net investment income.
• Balanced leverage profile, where there is no real reliance on fixed interest rate financing, which has been assumed at rates below the market level and must now be carried forward at much higher interest rates.

It’s not easy to find BDCs that have actually managed to structure their operations in a defensive way and can therefore serve the stream (and high-yield profits) safely. However, these are companies that, in my opinion, carry a significant margin of safety when it comes to distributing consistent and predictable income: Ares Capital (NASDAQ:ARCC) (see my article here), Gladstone Capital (NASDAQ:GLAD) (see my article here ), and the equity of PennantPark Floating Rate (NYSE:PFLT) (see my article here).

#3 Infrastructure

Investing in infrastructure is an excellent way to supplement a portfolio that seeks yield with stable income and growth over time. The essence of infrastructure investing is about capturing risk and return factors that fall somewhere between bonds and stocks.

Infrastructure assets generate cash flows that come from long-term agreements (just as in REITs), where pricing is already set, usually with periodic escalators and supported by strong tenants (or users of the asset). In addition, the underlying cash flows are not completely fixed or tied only to the CPI (or fixed bumps) as there is an opportunity for infrastructure funds to reinvest undistributed AFFO in new assets and, more importantly, monetize a portion of existing assets – operating projects And risk, thus unlocking value that can be invested in new projects.

The infrastructure business is inherently less risky than business development companies or real estate investment trusts that operate in volatile sectors such as shopping malls, offices and healthcare. However, when allocating in this area, it is still important to scope out companies that have strong balance sheets, conservative AFFO payment profiles and that have the lion’s share of cash flows based on predictable contracts such as PPAs (Power Purchase Agreements) or tariffs. Or public-private partnerships (PPPs).

In my portfolio, these three names make up the bulk of infrastructure exposure: Brookfield Renewable Partners LP Limited Partnership Units (NYSE:BEP) (see my article here), Brookfield Infrastructure Partners (NYSE:BIP) (TSX:BIP.UN:CA) (BIPC) (see my article here), Clearway Energy (NYSE:CWEN) (see my article here).

3. The main risk

The main risks in following an income-focused retirement strategy are well illustrated in the chart below.

Investing in income-producing assets, especially those that already offer a significant return from the start, by definition, means not focusing on the growth factor. This in turn leads to a potential opportunity cost, as the total wealth generated by the high and defensive dividend strategy is negative (compared to the allocation in high growth names).

This type of argument becomes even more relevant in the situations I’m in now – early 30s with a long-term horizon.

This is why I choose to implement a boring and conservative investment strategy to achieve my early retirement goals.

Firstly, I really don’t care if some asset or other investment strategy outperforms my income-producing portfolio. What matters to me is that the investments I have made provide stable and gradually growing current income streams, allowing me to reinvest more and more cash flows as the portfolio size increases, thus reducing reliance on my outside portfolio contributions in the process of achieving the portfolio size needed for retirement. Since the goal is to fund my living expenses with distributions alone and to do so by a fairly concrete date, fluctuations in the portfolio (or the underlying companies) do not matter.

secondTo maintain some upside options in my portfolio, I specifically introduced a small group of satellites within my retirement portfolio, where I could be more aggressive and deviate slightly from the basic strategy. This bucket takes up 5-7% of my portfolio, which is enough to capture other risk and return factors, while not imposing too many drags (and unpredictability) on the underlying strategy.

thirdDividend investing fits my emotional profile better, as accumulating regular cash flows and seeing them compounded with reinvestment, organic dividend growth, or additional contributions increases my chances of actually committing to this long-term strategy.

Bottom line

Investing in high-yielding, defensive sectors is a sound strategy for reaching retirement goals in a consistent and predictable manner if the overall motive is to cover living expenses with dividend income without having to withdraw shares from the underlying portfolio.

REITs, business development companies and infrastructure are asset classes that can help achieve this goal by producing permanent and growing current sources of income. Additionally, in terms of timing, this is a very attractive moment to buy these assets as more restrictive interest rates have pushed yields higher.

The main risk of large dividend or yield-focused stocks is the opportunity cost of not allocating them to growth companies. To mitigate this, investors can introduce a separate (although not very large) group into core portfolios, where specific investments can be made in growth and non-yielding sectors.