Goldman Sachs Preferred Stock: 5.2% Yield And 25% Potential Upside

| About: Goldman Sachs (GS)

Investors in Goldman Sachs (NYSE:GS) that desire more than the 1.3% yield the common shares offer may be forced to sell calls against their position or choose another security outright in order to produce some current income. However, there is a better option, in my view, in the Goldman Sachs Floating Rate Non-Cumulative Series A Preferred Stock (GS.A, may differ depending on your broker).

This preferred is offered to investors via a depositary that issues fractional depositary shares in the Series A Preferred Stock. With this issue, investors are entitled to 1/1000th of the Series A Preferred for each depositary share they own. Since the Series A has a liquidation preference of $25,000 per share, each depositary share has a liquidation preference of $25. This is important and we'll take a look at why now.

The Series A pays the greater of 3.75% or 0.75% above LIBOR on the dividend determination date. Basically, this security is likely to pay the 3.75% coupon rate for at least a few more years unless there is a violent increase in interest rates. The good news is that 3.75% is the floor in terms of the coupon payments for this security but there is upside eventually when LIBOR crosses above the 3% mark. When that will happen, nobody knows, but it has happened before and it will happen again.

Investors can reap some upside from this because this relatively low coupon rate has been priced into the depositary shares. In fact, despite the $25 liquidation preference, shares are languishing at $18.62 as of this writing. This means the depositary shares offer a massive 25% discount to the liquidation preference. This has two very important implications. First, the shares' at-first-glance lousy coupon rate is magnified by the low price of the shares. The current yield on the depositary shares is 5.15%. Second, should GS decide to liquidate these shares, holders of the Series A depositary shares would be entitled to a 25% capital gain. GS can only redeem these shares at 100% of the liquidation preference so if that occurs, investors can not only obtain some current income in the interim but also a massive capital gain when and if GS decides to liquidate the shares.

The shares became callable in 2010 and could be called at any time at Goldman's discretion. In addition to this, the shares are non-cumulative. This means that if GS misses a dividend payment or fails to declare one, it is under no obligation to make up the payment. This is a sizable negative for this security as cumulative is, of course, much more desirable than the former. However, keep in mind that common stock is also non-cumulative; it is simply a risk of owning an interest-paying security. Considering the ramifications for missing a payment, I don't think it will happen. However, it is a risk to consider.

The Series A offers investors not only the chance to receive 5%+ in current income paid on a quarterly basis but also the strongest investment banking franchise in the world as the borrower. While the dividends are non-cumulative, the Series A has always paid and given the recent decline in the price of the shares, the Series A now offers 25% in potential upside should GS decide to call the shares. This offers investors not only good current income but the opportunity for large capital gains as well. And when interest rates do begin to rise, the coupon of this security will participate in the upside. This would also make it more enticing for GS to call the security when interest rates rise, locking in potential capital gains for holders of the depositary shares.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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