Safety, Yield and Total Return in Preferred Stock Floaters of Goldman Sachs and Metlife

Includes: GS
by: Dan Plettner

When most people think of Preferred Stocks, they think of retirees investing $25 a share after a broker’s cold-call in the primary (issuance) market. I suggest looking at the secondary market, with a current perspective on these highly liquid exchange-listed securities. I will highlight situations where I believe the risk of owning preferred stock as an alternative to cash, money market, or CDs is minimal compared to the reward of increased yield and prospects for principal appreciation.

Preferred Stock is above Common in the food chain; clearly defined preferred dividends must be paid ahead of the discretionary dividends which Boards desire to pay to common stock holders. Preferred stocks have long been used by retirees and savvy insurance companies for stable income. Investment in Preferred Stock entails assessing solvency rather than speculating on a strong upward trajectory for one business or “the market” in general. Surprisingly, taking less risk does not require sacrificing exceptional anticipated total return. It can be purchased through any brokerage account, just like any stock that trades on the New York Stock Exchange.

There are tremendous inefficiencies in the market for Preferred Stocks because the suitable retail investor is focused only on the current yield. In reality, total return is more dependent on future dividends and changes to market value. Savvy investors who want not only current income today, but anticipate that short term rates will not remain near zero forever, can find tremendous opportunities in the few Preferred Stocks which are currently paying a “Floor Rate”, but are categorically Floating Rate Preferred Stocks (“Floaters” ) by definition. Given surprising relative strength in the November Jobs Report in arrears of Fed Policy makers noting for the first time in minutes of their Nov 3-4 meeting that current policy may be fueling undue financial-market speculation, it is actually more important to now contemplate the upside of Floating Rate provisions and the effect such provisions can have on the future market value of shares.

I believe the best current opportunity in the Preferred Stock universe is Goldman Sachs (NYSE:GS) Series A (GS.PR.A). Its current market yield is 4.66% of its market price but more importantly that market price is deeply depressed because the current yield is all “Floor” (3.75% of $25 issue price) and no “Float” (GS.PR.A pays LIBOR + ¾% on the far-above-market $25 issue price in normal rate environments). To be clear, each quarter shareholders are entitled to the greater of the “Floor” or the “Floater” provisions as a dividend.

There are plentiful Flat Rate Preferred Stocks with greater slightly greater current yields but a flat dividend becomes less attractive in a rising rate environment, whereas investors of Floaters such as GS.PR.A can see both increasing income payments and increasing market value. Let's discuss the Goldman Sachs Flat Rate as a point of comparison GS.PR.B currently pays about 1.5% more current market yield, but that is petty in comparison to a prospective 30% variance in market value of principal which I anticipate by the time the FED has substantially begun to normalize rates. And, of course there is no telling which will be paying a higher a yield on today’s invested dollars in one to three years.

GS.PR.A is currently the most attractive within the tiny niche of Floaters in my view. GS.PR.C and GS.PR.D have less upside in my view but do share both the credit quality and unique prospects which derive from Goldman as an opportunistic issuer. Any issuer could take advantage of the current rate environment and a depressed market price, tendering as JP Morgan recently did to retire higher face obligations at a discount price. Such a move would likely anticipate not only a normalization but even a regression-to-the-mean in short term rates.

In my research for this article, I approached and conferred with a well recommended financial sector analyst, who opinioned that the Goldman issues have essentially zero default or dividend risk. The analyst also noted Goldman’s anticipation of normalized rates being more rapid than the view of his own firm. He did perceive that a Tender was more likely than Goldman retiring shares through secondary market purchases, and that GS.PR.A was the most likely target.

While I do not recognize any other Floaters to be of equal current opportunity for the same class of relatively risk-averse investors, I do understand that the Metlife (NYSE:MET) Issue (MET.PR.A) shares minimal default risk. Also, for any given level of default risk I believe the entire class of Floaters has superior total return upside to the more popular Flat Rate Preferred Stocks, such as BAC.PR.J or WFC.PR.L. The extra current yield coming from the Flat Rate variety is of minimal relevance to the likely principal outperformance of Floaters. The attractiveness and thus market value of Flat Rate Preferred Stock can decline significantly in increasing interest rate environments .

Other Floaters by definition which I consider to be of a far inferior risk profile to the Goldman and Metlife issues, and thus inappropriate for direct comparison include UBS.PR.D, HBA.PR.F, and Bank of America’s (NYSE:BAC) BAC.PR.E and BML.PR.L. Standard and Poors (S&P) did raise its preferred stock rating Friday on Bank of America with consideration of the banking giant’s plan to repay $45 bilion to the U.S. Government. I maintain a different view whereby the move actually makes Bank of America Preferred riskier. Market forces also have dissented from S&P’s view. On the upgrade, BAC.PR.E and BML.PR.L each traded downstream by more than 1% within an otherwise strong market for Floaters.

Disclosure: Long GS.PR.A and MET.PR.A. No other positions