GS Finance’s principal-protected notes tied to basket show reasonable tenor, no cap

By Emma Trincal

New York, April 10 – GS Finance Corp.’s 0% market-linked notes due Sept. 20, 2023 linked to an equally weighted basket consisting of the Euro Stoxx 50 index, the S&P 500 index and the Topix index offered the unusual appeal of providing full downside protection with no cap on the upside while keeping the term relatively short at four years and four months, sources said.

The payout at maturity will be par of $10 plus the basket return, subject to a minimum payout of par, according to an FWP filing with the Securities and Exchange Commission.

Typically, principal protection at 100% requires longer maturities. Issuers sometimes use low-volatility proprietary indexes to achieve shorter terms. In other cases, much shorter-dated notes can be created with knock-outs, which once they’re triggered, eliminate the participation.

In this case, the current shape of the yield curve, the use of basket as the underlying and the unleveraged upside concurred to make the pricing feasible, explained a sellsider.

No term premium

Last month and for the first time since the financial crisis, the spread between the 10-year U.S. Treasury yield and the three-month yield turned negative, causing an inverted yield curve, he first noted.

The spread has turned positive since but remains extremely tight. With the 10-year yielding only 4 basis points more than the three-months, the curve is – if not inverted – at least virtually flat.

“People focused on the signal that an inversion represents when it happened. Many times, it precedes a recession,” this sellsider said.

“But for structured products what it means really is that time value is gone. You can choose your maturity as you want without much differential between the short and the long term.

“Bottom line: if you do principal-protection, you’re better off going short.”

Diversified portfolio

His second comment pertained to the underlying.

“This is not on the S&P. This is on a basket of three indices,” he said.

“A basket option is always cheaper than the sum of the three individual options. The imperfect or lower correlation between the three indices cheapens the cost of the call.

The basket also reduces the overall volatility of the underlying, which cuts the cost of purchasing the derivatives.

“It’s not very expensive to buy the call option.”

Zero-coupon pricing

Principal-protected notes are composed of a zero-coupon bond and a call option.

Zeros are issued at a discount to their face value, which ensures protection at maturity and frees up capital available for the issuer to buy the necessary options.

“The question is how many calls you can buy on a basket options when you buy a zero-coupon,” this sellsider said.

“On the S&P, if you buy a four-and-a-half year at-the-money call, it will cost you 14%. But you only have 11% at your disposal from the zero.”

He assumed the 11% figure based on a 2.5% interest rate over the period. He priced the 14% option cost.

The term at-the-money for an option contract is the equivalent of the initial price of the underlying with the note. Any increase above it will generate a gain.

“You don’t have enough. You need to cheapen the cost of the call,” he continued.

“They take two other indices, including the Euro Stoxx, which is particularly cheap.

“That’s how they do it.”

Investors in the notes have to forfeit dividends. As the Euro Stoxx 50 index yields more than 3%, it brings an additional source of revenues allowing the issuer to structure the deal.

Another factor was a participation limited to 100% of the upside. When enough capital is left from the zero-coupon bond, issuers can in some cases add upside leverage. In this case the participation is limited to a one-to-one exposure.

Overvalued U.S. market

Despite a seemingly less volatile underlying due to the diversification between three indexes and also despite the full protection, some were not impressed with the notes.

“From the surface, it looks interesting,” said Andrew Valentine Pool, main trader at Regatta Research & Money Management.

“I would have to do more research on the indexes, especially on the Topix.”

But Pool was not particularly motivated to buy the U.S. benchmark even as a basket component.

“The S&P reached a high in September and has already recouped most of the losses from the fourth quarter,” he said.

“We think it’s really at a high.

“Our style is to enter the market looking at technicals. We prefer to buy when there is a pullback versus when it’s peaking.”

The full downside protection could take care of the downside market risk. But even if the market continues to rally, an overvalued asset may not generate high returns, in which case having no leverage could hurt the overall performance, he said.

“We stay away from the S&P in general unless we can get high leverage to make up for the lower returns. We also need to see some downside protection. This condition would be met in this case. But it’s not enough,” he said.

The notes will be guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the underwriter. Morgan Stanley Wealth Management is acting as dealer.

The notes will price April 26.

The Cusip number is 36257D436.

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