A 5.10% Yielding Preferred Stock To Save You From Interest Rate Risk

| About: Goldman Sachs (GS)

Summary

Low interest rates scare a lot of long-term preferred stock investors.

Floating rate preferred stock offers almost the same current yield while hedging your interest risk.

Switching to this stock has fundamental and statistical logic.

In my recent article I got a very interesting comment from an investor with many years of experience. He does not like fixed income because of the interest rate risk in the current low rate environment. As a trader I do not pay much attention to this, because I am flexible and always know how to hedge and eliminate this risk, but I decided to look in my database and find a stock that eliminates interest rate risk while bringing a decent current income for the long-term investor who is not trading on a daily basis.

The article is about Goldman Sachs (NYSE:GS) floating rate preferred stock (GS-D), but before we start I would like to take a look at some fundamental charts that are a must to understand the valuations used.

The charts show LIBOR, the Fed funds rate and 10-year treasury yields.

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Source:research.stlouisfed.org

The point of showing those 3 charts:

  • LIBOR rate closely tracks FED funds rate
  • LIBOR rate is more volatile than 10-year treasury yield (making sharper moves)
  • The discount rate used for preferred stocks valuations is the 10-year treasury yield (their yields are widely compared using the 10-year treasury yield as the risk free alternative)
  • At current levels LIBOR rate has more potential to reach its 2006 high than 10-year treasuries (as we all know, history tends to repeat itself)
  • It is quite possible at some moment in the future to have the LIBOR rate at 5.62% (this will eventually happen in 5, 10, 15, 20 years)

GS-D current valuation and comparisons.

GS-D is a BB rated floating rate preferred security that pays the higher of 4% or 3 month LIBOR + 0.67%. Currently it pays a $1 dividend per year, which at the current price of $19.62, means the current yield is 5.10%. When comparing current yields, GS-D is the best yielding floating rate preferred:

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Compared to the current yield of the newly issued Goldman Sachs 6.30% fixed rate preferred stock (GS-N), the current yield spread is 1%. Current yield is important only when a security is trading bellow par (being the yield to worst). Compared to the GS preferred stocks family, GS-D's yield to worst is the same as GS-K's yield to call. The yield to worst spread to GS-N is just 0.40%:

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I have been monitoring the current yield spreads between fixed rate preferreds and floating rate preferreds for the last 8 years and have never seen the spreads so narrow for such a long time. The only fundamental reason that can justify such a narrow spread is the assumption that interest rates will remain low for a very long time.

Why is GS-D the better investment currently?

All the comparisons made above do not show how undervalued GS-D really is. The market is so focused on current yield that it neglects to consider the time value of money. All the fixed rate preferred securities bring interest rate risks. The last big fundamental drop in preferred stock prices was when the 10-year treasury yields started climbing to the 3% mark. I am sure all preferred stock investors remember the end of 2013. Some preferred stocks dropped by more than 20%, because of the parallel shift in the yield curve. The only preferred stocks that can save the income investor from interest rate risk are the floating rate preferred issues that are likely to appreciate in price or at least to not fall as much as the fixed rate preferred issues. It is noteworthy to mention that this interest rate protection will work only if the LIBOR rate raises. It is quite possible for the treasury yields to raise without the LIBOR responding (we have seen all kinds of scenarios since 2008).

How to evaluate a floating rate security like GS-D
I am personally using 2 models for evaluating floating rate preferreds that have worked for me through the years, but since it is something that I have personally developed, I am open to hearing your constructive critique to improve my modeling.

  • Determining fair price based on interest rate expectations. As seen in the LIBOR chart provided in the beginning of the article, in 2006 the LIBOR rate was at 5.62% while the 10-year treasury yields were close to 5.20%. I assume this will happen again in the future. GS-D was issued in May 2006 (GS surely know when to issue a floating rate issue) and was well accepted by the public at $25 per share. The valuation of a floating rate preferred stock is dependent on your interest rate expectations. On this chart you can see the internal rates of return and present values for the following 3 scenarios:
  • LIBOR rises to 5.60% in 5 years
  • LIBOR rises to 5.60% in 10 years
  • LIBOR rises to 5.60% in 15 years

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Based on your expectations of interest rates, you will determine GS-D's present value as shown in the model. I have used a discount rate of 5.5% for the 5-year calculation, 6.5% for the 10-year calculation and 7.5% for the 15-year calculation. The increase in the dividend is also not included in the model to make it a little bit more simple, but since everyone has different views, I think that the whole idea of how to evaluate a floating rate security is important, not the details (just by choosing a different discount rate, you change the valuation significantly).

  • Comparing to a preferred stock with the same credit risk. If at some point in the future we have the LIBOR rate at 5.63%, this will mean that GS-D and GS-N are basically the same stock at that particular moment and we can make the naive assumption that they will trade at similar prices (this is not a 100% accurate assumption, but for the purposes of calculations, we will make it). We make the assumption that when the LIBOR rises to 5.63%, the two securities will trade at the same price. I have chosen a price of 23.5 for calculations and the price itself is irrelevant. What is important is that the spread in IRR for the 2 securities is almost the same no matter what price they "meet."

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Source: Author's database.

This method provides the same conclusion as the first -- the faster you believe the LIBOR rate will increase, the more you like GS-D. What those calculations actually show is that GS-N is the better investment, only if you believe that the LIBOR will not increase to 5.60% in less than 15 years.

Statistical prove

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Source: Google Finance

This chart compares GS-D to the fixed rate preferred stock GS-B. Those two stocks were trading at similar prices in 2006 when the LIBOR was at its highs. This will be the case in the future if interest rates raise significantly. It is very important to point out that even an expectation of such an interest rate hike will drive the price of GS-D close to the prices of its fixed rate preferred stock family

How do I trade it?

I am not a 5.1% long-term investor. However logical that is, I just do not want to have my long-term investments locked in at those low yields offered by financial preferreds. I am trading this stock only for the capital gain it can provide on the changing sentiment on interest rates. Do not expect something drastic to happen to it in the near future, but I do like the logic behind it and think that the stock is currently undervalued by a dollar. This will be my short-term target for it and I am adding it to my arbitrage trading portfolio as a naked long pick and will probably close it at around 20.60 and average it down on the way to 18 (if it starts falling).

Conclusion. The market is all about current yield. Current yield is like the discount you see on an advertisements. You think you got a good deal and two days later, you see the same product being sold cheaper without a discount. GS-D is a good stock to consider for hedging your interest rate risk, but there is one big risk, and that is the unknown future behavior of interest rate spreads. It is quite possible for the treasury yields to rise while the LIBOR stays at its lows. Actually, anything is possible (we have negative interest rates). Even if GS-D fails to hedge interest rate risk, it is still not that bad of a deal compared to its preferred stock brethren.

Disclosure: I am/we are long GS-D.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.