Goldman Sachs' callable range accrual notes linked to S&P 500 are designed to boost income

By Emma Trincal

New York, July 9 - Goldman Sachs Group, Inc.'s callable monthly S&P 500 index-linked range accrual notes due July 29, 2028 target investors seeking higher yields, sources said, adding that some risks need to be considered such as interest rate risk, credit risk and the possibility of an early redemption at the discretion of the issuer after one year.

Interest will accrue at 6.25% per year times the proportion of days on which the index closes at or above 75% of the initial index level. Interest is payable monthly, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par.

Beginning July 29, 2014, the notes will be callable at par on any interest payment date.

Yield play

"This is for someone who wants an above-average interest rate," said Tom Balcom, founder of 1650 Wealth Management.

"Although you're using the equity volatility to obtain a higher yield, you're still exposed to the risk of seeing the value of your notes negatively impacted if rates go up, like with any other bond, unless of course you get called - but this is not really what you want - or unless you hold it to maturity.

"Assuming it doesn't get called, it's a juicy coupon, but you have a 15-year time horizon. I don't know any investor who has a 15-year time horizon. The structured notes we do with our own clients are 24-month or less. I guess the motivation is to beat the 2.75% 10-year Treasury and get a competitive rate.

"But you're not getting rid of other risks such as credit risk and interest rate risk. Interest rate risk is the biggest risk. Your principal may be protected at maturity, but if you want to sell before that, your bond will be worth less if interest rates go up and you won't have the best liquidity."

Not a range

Michael Iver, founder and chief executive of iVerit Consultancy and a former structurer, noted that the term "range accrual" notes may not be totally accurate in the case of this product.

"The term 'range accrual' is typically applied when you have a lower boundary and upper boundary on the floating index. This one is not really a range because the coupon doesn't go away if the market rallies. You only have the lower barrier, which is the 75% trigger," he said.

"It would be a range if the index had to stay within 25% up and down of the current value. In this case, you would be selling calls and puts."

The call could be seen as an upper value, he said, but it really is not because its value is "undetermined" as the call event is left at the discretion of the issuer.

"So you can't really call it a range," he said.

The notes are designed to provide a yield potentially higher than comparable instruments, according to the prospectus.

"It's an income play," he said.

"You're taking the equity volatility and creating a fixed-income note.

"You're getting a coupon as long as the index is above [the] 75% threshold. So you're selling a 25% out-of-the money put option."

Early redemption

Investors need to consider the risk of being called after one year, he said.

"This product is for someone who expects the market to trade flat for the next 15 years or lower, in which case the notes won't get called and you will get your 6.25% coupon for the next 15 years. Alternatively, it could be for someone who doesn't care if the market rallies and they get the coupon only for one year. What you don't want is a market that will trade off because then you would be stuck with the notes," Iver said.

For Iver, investors would have a hard time evaluating the interest rate risk given that the length of the product is not fixed and could be shortened any time should the issuer call the notes.

"It's a 15-year note, but it's callable. It may not be a long-duration note due to the call feature," he said.

"If the S&P rallies, it will be called. It will be either a one-year or a 15-year or more likely something in between. The level of interest rate risk is a function of the probability of being called. The lower the probability, the greater the interest rate risk.

"The best market condition for the investor would be for the market to not appreciate over the next 15 years. More specifically, the market would have to trade sideways or decline slightly, and volatility would have to diminish. Then the issuer would be less likely to call the note than in the case of a rally."

Liquidity risk

In the absence of a call, investors who would want to sell their notes prior to maturity would face liquidity issues, said Iver.

"With a note that is structured with all these options, the investor would potentially be limited to the secondary market-making of the issuer.

"Depending upon the size of a regular bond and the investor base - for instance if the client is a buy-and-hold investor like a pension or endowment fund or, in contrast, a trader - one would expect this note to have much less liquidity," he said.

"For a regular corporate bond, the market-maker needs to hedge the interest rate and credit risk ... whereas in this note there are a slew of S&P 500 options that need hedging. The higher the cost of hedging, the wider the bid-offer and the lower the liquidity."

The notes (Cusip: 38147QFS0) are expected to price July 24 and settle July 29.

Goldman Sachs & Co. is the underwriter.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.