2017 has barely started and this is already my second article about floating rate preferred stocks. This is no coincidence, however, as floating rate securities are all the rage right now. Everybody is talking about rising interest rates, and floating rate securities are largely seen as a way to protect oneself from the interest rate risk. In my previous article, I spoke about a pair trade opportunity in two of Bank of America's (NYSE:BAC) floaters, and in this one, I will focus on a similar mispricing in three Goldman Sachs (NYSE:GS) securities. The circumstances are very similar to the ones in my previous article, so let me quickly dive in and get you acquainted with those.
First, the securities. The three instruments in question are Goldman Sachs' Series D Float Rate Non-cumulative Preferred Stock (GS-D), Series C Float Rate Non-cumulative Preferred Stock (GS-C) and Series A Float Rate Non-cumulative Preferred Stock (GS-A). My proposition is that GS-A is relatively overpriced when considered in the context of GS-D and GS-C, and I will try to show you why I think so in the following paragraphs.
Let's start with some of the metrics for the three securities. You can see them in the table below.
Source: Author's spreadsheet
Before I comment on the yield metrics above, I will give you some background information about the three securities. All of them rank pari passu in GS's capital structure and thus, not surprisingly, bear the same credit rating of BB+. Also, I mentioned that GS-A, GS-C and GS-D are all floating-rate securities, but what I didn't mention is that all three of these securities have different spreads over LIBOR. For GS-D, the spread is 0.67% and for GS-A and GS-C, it is 0.75%. This fact is of little importance, however, and I will explain why. All three GS securities have an embedded floor option. For GS-A, its strike is 3.75%, and for GS-C and GS-D, it's 4%. Since current interest rate levels are so low, all three floor options are now at the money, meaning that all three securities are paying the interest rate determined by the strike price of the floor options. So, it is of little significance what spread over LIBOR the three preferred stocks are commanding because at the current interest rate levels, all three of them are paying a fixed rate. And since they are all paying a fixed rate, their behavior is similar to the one expected from a fixed rate security.
OK, now that I have explained why you should treat GS-A, GS-C and GS-D as fixed rate securities at the current level of interest rates, let's check out what each of the three GS securities is yielding. One thing to notice is that all three instruments are callable, but I see the probability of any of them being called as very low. Why is that? Just look at their nominal yields. If you were a financial institution, would you expect to pay such low nominal interest rates on securities with a below investment grade rating? I would not. If I could see why 4% is very low for a BB+ rated security, my guess is that people at Goldman Sachs could also see that.
With call probability being low, it is best to treat GS-A, GS-C and GS-D as perpetuities. And the best way to compare perpetuities is by using the current yield metric. While GS-C and GS-D have a current yield of 4.49%, GS-A is yielding much less - only 4.07%. Now you can see why I believe GS-A is overpriced when compared to GS-C and GS-D. Another way to understand why I consider GS-A overvalued is through the picture below.
Source: Author's spreadsheet
The chart on the right shows how the spread between the prices of GS-A and GS-D has changed over the past 100 days. Notice that for most of the time it has moved in a relatively tight range, but that has recently changed. Currently, the price spread is $0.7, which is more than 2 standard deviations away from the mean value of -$0.07. The chart on the right tells the same story, but in a different way. The graph indicates how the difference in the current spread between GS-A and GS-D has changed over time. Again, you can notice the same dynamics as the one in the first picture - the current yield spread between GS-A and GS-D has moved in a tight spread for pretty much the whole chart period (100 days), but recently, it has broken below the lower barrier of the range.
My overall take from all stated above is that GS-A has deviated from GS-D and GS-C not only fundamentally, but also statistically. That makes me even more convinced that GS-A is overvalued when compared to its siblings.
So what is the reason for the mispricing? After all, nothing has changed fundamentally. Why then is GS-A trading at a premium to the other two? My go-to answer here, is not much different from the one that I pointed out in my article about the Bank of America's preferred stocks - supply and demand mismatch. Why are investors focusing on GS-A, rather than GS-D and GS-C, you would ask? Well, everyone is entitled to his/her own theories, but my guess is that as the strike price of the floor option is lowest for GS-A, the preferred stock is the most likely candidate of the three securities in this article to switch from being a fixed-rate security to being a true floating-rate security. Is this a good enough reason for the mispricing? Of course not. I continue to assert that the widening of the spread between GS-A on one hand and GS-C and GS-D on the other is purely driven by demand and supply forces. As a result, I expect that once demand resumes to more reasonable levels or is met by enough supply, GS-A will trade closer to its GS brethren once again.
Now that we are on the same page in terms of the relationship between GS-A on one hand and GS-C and GS-D on the other, it is time to think of way to take advantage of the mispricing. My preferred way to do that is through a pair trade that bets on price spread tightening between two securities. For this particular case, I choose to go short GS-A and go long GS-D. I prefer GS-D over GS-C, because the Series D has a higher historical correlation with GS-A and is also more liquid than the Series C. You can see how strong the relationship between GS-A and GS-D has been in the past in the chart below.
Source: Author's software
Portfolio 1 and Portfolio 2 are hypothetically equally-weighted portfolios invested in GS-A and GS-D respectively. Notice that the two portfolios have tracked each other very closely until recently when the relationship between the two has weakened. Just to put that in numbers - the 200-day correlation between GS-A and GS-D is 0.96, while the 40-day is only 0.82.
With the pair trade I am suggesting, I will be betting on the profit/loss spread between the two portfolios returning to historical levels. You can also put that in the perspective of the price spread between GS-A and GS-D. As I already mentioned, that spread is currently $0.76, while the average over the last 100 days is -$0.07. So, I see the potential of the trade being around 50-60 cents.
Lastly, a practical remark. GS-A is difficult to borrow for shorting purposes and the price to borrow it is also steep, so be mindful of that fact, if you want to take advantage of the pair trade. Also, take some time to consider your risks and costs of holding the position for an extended period of time. That's something that I am doing every time when I am thinking of opening a position.
The new year is already offering us some opportunities to make money. Not surprisingly, the opportunities are in floating rate securities, which are attracting a lot of attention from market participants. I recently wrote about a mispricing in some of Bank of America's preferred stocks, and in this article, I devoted some time to three of Goldman Sachs' preferred stocks.
The surge in interest in floaters has pushed the price of GS-A way ahead of those of GS-C and GS-D. I haven't been able to identify any fundamental reason for the move, and thus I believe that the mispricing is purely driven by a demand-supply mismatch. Once the demand eases or is met by enough supply, I believe GS-A would start trading in line with its other two brethren.
If you currently have GS-A, I would strongly suggest you replace the preferred stock with either GS-C or GS-D in your portfolios. If you would rather engage in a pair trade in order to take advantage of the mispricing, bear in mind that there are some costs you need to consider in advance.
Disclosure: I am/we are short GS-A.
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.