Have you ever felt the desperation that comes from not having enough money? It’s not a pleasant feeling.

But it’s one the iconic investment bank, Goldman Sachs (GS), felt deeply back in 2008.

In the wake of the Bear Stearns and Lehman Brothers collapses, Goldman needed to send a strong message to the markets that it could remain solvent. The only problem? It had few options to raise capital with credit markets frozen.

[ad#Google Adsense 336×280-IA]So it turned to one of the most prominent investors in the world for a lifeline – Warren Buffett.

He arrived on the scene with a $5-billion cash infusion – a transaction designed not only to bolster Goldman’s capital, but to also inspire confidence in the entire financial system.

Unfortunately for Goldman, the money came at a steep cost.

But the nature of the deal contains an investing lesson we should heed immediately…

Be Greedy When Others Are Fearful

In exchange for the $5 billion, Buffett received preferred shares with a 10% yield. Goldman also gave $5 billion in warrants to Buffett, giving him the option to purchase common shares in the future for $115 – at a time when the stock price was $125.

Talk about a sweet deal!

With fears of a systemic financial collapse now a distant memory, Goldman has since repurchased Buffett’s preferred shares and restructured his warrant position.

Buffett bought during a time of panic and was rewarded handsomely.

Granted, opportunities like Buffett’s deal are rare. We shouldn’t expect to get a call from Goldman any time soon offering us amazing terms for our money!

But preferreds still represent great income investments in this yield-deprived market, especially when other investors are fearful of them. Like Buffett, we can capitalize on some sweet deals…

Preferred Interest

We received a ton of positive feedback on our trust preferred securities article earlier this month. It’s become apparent that many of you want more of these low-risk income generators. So here’s another option to consider – the Goldman Sachs Perpetual Floating Rate Non-Cumulative Series D Preferred Stock (GS-PD).

As the name suggests, these preferred shares pay a floating interest rate that changes over time.

Specifically, they pay the three-month LIBOR rate plus 67 basis points. At current prices, the shares yield an attractive 5.08%.

They also carry a minimum dividend payout of 4%. No matter what happens with interest rates, these preferreds will always pay at least 4%, based on the liquidation value of $25.

The shares are currently trading hands for $19.68, equal to a 21% discount to the liquidation value of $25, so there’s potential for healthy price appreciation.

The shares are non-cumulative, which means that if Goldman misses dividend payments, the company is under no obligation to make up the missed payments in the future.

And while we generally prefer cumulative dividends on preferred stocks, Goldman is systemically important. So it’s extremely unlikely that it will miss any dividend payments. We can take comfort in the fact that the Fed and the U.S. Treasury bent over backwards to make sure Goldman didn’t fail during the financial crisis.

One big advantage of this preferred is that its payouts are taxed at a lower rate (15% in most income brackets) than ordinary income. This preferential tax treatment gives it an advantage over other income securities, such as bonds.

So why aren’t investors more enthusiastic about preferred stocks for a steady stream of income?

Perpetual Worries

A common concern with perpetual securities, such as the Goldman Series D Preferred, is their vulnerability to rising interest rates. In fact, we’ve already received several emails asking, “Will my preferred stock get crushed when the 10-year Treasury rate rises to 4%?”

Such fears are misplaced.

Consider: The post-financial crisis high for 10-year Treasuries is 3.98% (reached on April 5, 2010). Yet, on that day, the Goldman Series D Preferred closed at $22.48. That’s 14% higher than the current price.

Back in 2007, 10-year rates peaked at 5.29%. At that time, the fed funds rate was at 5%… and yet, the Goldman Series D Preferred was trading at $25.78, which is 31% higher than the current price. It also yielded 5.7%.

And that’s the beauty of floating-rate preferreds. Payouts will rise as short-term interest rates rise above a certain level.

Bottom line: Worries about the banking system have been replaced with anxieties about rising rates. As we learned from Mr. Buffett, it pays to be bold when others are uncertain.

The Goldman Sachs Perpetual Floating Rate Non-Cumulative Series D Preferred Stock is a perfect example. Grab this 5% yield while others are still fearful, and keep your eyes on your inbox for more contrarian opportunities from the D&I research team.

Safe investing,

Louis Basenese


Source: Dividends and Income Daily