2024-01-10 07:00:00 ET
Summary
- FOMC predicts 75bps in interest rate cuts this year, suggesting a peak in rates.
- Strategies to protect income during declining rates include buying long-duration funds and fixed-rate bonds with long Call protection and distant maturity dates.
- Article analyzes two floating rate preferreds issued by Goldman Sachs to determine if buying assets with a floor on the coupon is a good approach.
- At least between these two preferred stocks, while the floor was a plus pre-COVID, the floor-less floating-rate formula used by K is superior but still only a Hold rating.
Introduction
If, as a fixed income investor, you believe FOMC’s December statements as I understand them, we have seen the peak in interest rates. The read is 75bps in cuts during this year, though that has become less certain as we enter 2024. Possible strategy choices to protect income during declining rates include:
- buy long duration funds
- buy fixed-rate bonds with both long Call protection and distance maturity dates
- buy assets that float but come with a floor the coupon cannot fall below
This article covers two floating rate preferreds issued by Goldman Sachs to see if the last strategy listed above is a good approach. They are:
A key part of the analysis will address the value of having a floor under the future coupon, which D offers, but K doesn’t offer. The answer was Yes for the past decade until the recent jump in interest rates. To answer the question posed in the Title: not since rates soared. Even with K's floating-rate formula being superior, it only rates Hold rating as I fear it will be Called soon. For those who agree, D provides a decent but probably declining coupon currently, which I also rate as a Hold then.
The Goldman Sachs Group review
Since seasoned investors know what Goldman Sachs does, only a brief overview is presented. What a preferred stock investor needs to know is whether there is any default risk. Keeping in mind even “solid” firms fell, remember Lehman Brothers, I feel the protections in place since the GFC means that risk should be very minimal.
Seeking Alpha describes this company as:
The Goldman Sachs Group, Inc., a financial institution, provides a range of financial services for corporations, financial institutions, governments, and individuals worldwide. It operates through Global Banking & Markets, Asset & Wealth Management, and Platform Solutions segments. The Global Banking & Markets segment provides financial advisory services, including strategic advisory assignments related to mergers and acquisitions, divestitures, corporate defense activities, restructurings, and spin-offs; and relationship lending, and acquisition financing, as well as secured lending, through structured credit and asset-backed lending and involved in resale agreements.
Source: seekingalpha.com GS
Shareholders Equity is over 10x the value of all the preferred stock outstanding.
seekingalpha.com GS Balance Sheet
Reviewing and comparing the two preferreds
Goldman Sachs has other preferred stocks too but I felt these two provided the best contrast for this article.
QuantumOnline.com GS-D QuantumOnline.com GS-K
Factor | GS D | GS K |
Issued | 5/18/06 | 4/21/14 |
Size | $750m | $700m |
Current coupon | 6.4%est | 6.375% |
Coupon rules | 3mo-SOFR+26.161bps+67bps | 3mo-SOFR+26.161bps+355bps |
Coupon floor | 4.00% | NA |
Price | $21.90 | $25.40 |
Yield | 7.4% | 6.3% |
Call/float date | 5/24/11 | 5/10/24* |
* As noted in the description, because this preferred can no longer be included in Tier 1 capital, it could be Called before next May.
Both preferreds have converted from the original 3mo-LIBOR to the 3mo-SOFR + 26.1616bps, which adjusts for the risk difference between the old and new benchmark rate. For the floor to come back into effect for Pfd D, the 3-mo SOFR would need to drop below 3.07% from the current range around 5.3%.
Portfolio strategy
Between these two preferred stocks, the basic trade-off is the floor D provides versus the much higher floating component that K provides, which almost equals the floor provided by D. This is how the two coupons would move as the 3-mo SOFR changes.
3-Mo SOFR | D coupon | K coupon | B/E Price |
200bps | 4.00% | 5.81% | $17.21 |
300bps | 4.00% | 6.81% | $14.68 |
350bps | 4.43% | 7.31% | $15.21 |
400bps | 4.93% | 7.81% | $15.75 |
450bps | 5.43% | 8.31% | $16.37 |
500bps | 5.93% | 8.81% | $16.80 |
550bps | 6.43% | 9.31% | $17.29 |
The Breakeven price column shows the price D would need to sell at to match K's yield if K was at $25 and its coupon was floating.
- Currently D yields about 110bps above K but that should more than reverse when K starts floating in months.
- Technically, both are currently Callable, and with K’s potential new coupon jumping to over 8%, I would rate that as a high risk. K currently trades above Par so that adds to the risk of buying/holding this preferred.
- D’s floor won’t be activated without a large drop in the SOFR. As the above table shows, D seems overpriced even with its current yield exceeding K’s: $21.75 versus comparable estimated price near $17 (assuming my math was correct).
- While I think D is overpriced, when compared to GS.PR.C , with almost the same floating-rate formula, it is not, or they both are. Same goes when compared to GS.PR.A . There are only small differences in the floating formula used by each of those.
While K's floating-rate formula is superior, it only rates Hold rating as I fear it will be Called soon. For those who agree, D provides a decent but probably declining coupon currently, which I also rate as a Hold. The other preferred would also rate a Hold based on their floating-rate formulas.
For further details see:
Goldman Sachs Preferred D Vs. K: Does Coupon Floor D Have The Better Strategy?