Goldman Sachs’ $82.1 million contingent coupon notes linked to currencies seen as ‘coin flip’

By Emma Trincal

New York, Sept. 22 – Goldman Sachs Group, Inc.’s $82.1 million of contingent coupon notes due Dec. 19, 2019 linked to the performance of a basket of currencies relative to the euro offer an “interesting structure” with almost full downside protection, buysiders said.

But betting on the movement of a currency for a five-year period while the coupon is not guaranteed makes the investment too uncertain, a buysider said, or even similar to a “coin flip,” another one added.

The basket includes equal weights of the Canadian dollar, the Mexican peso, the U.S. dollar, the British pound and the Norwegian krone, according to a 424B2 filing with the Securities and Exchange Commission.

By purchasing the notes, investors are taking a bearish view on the euro against the basket, which means that they expect the basket return to be positive. The exchange rate for each currency is expressed as the number of units of that foreign currency per euro. A currency return will be positive if it takes fewer of the relevant currency to purchase one euro than on the pricing date.

Euro bearish play

Each year, the notes will pay a 9% coupon if the basket return is zero or positive. If the basket return is negative, no coupon will be paid that year.

At maturity, if the basket return is positive or zero, the payout will be par plus the basket return. If the basket return is negative, investors will lose 1% for each 1% that the basket declines, subject to a minimum payout of 90% par.

Tom Balcom, founder of 1650 Wealth Management, said that the downside protection is the most appealing aspect of the deal. But he sees the underlying currency bet and the length of the notes as negative points.

“They are limiting the downside to 10%, which is good,” he said.

“I like the fact that your loss is capped. On this note, you know in advance the worst-case scenario. ... Even if the basket is down 30%, you will only lose 10%. With a 10% buffer, if this basket is down 30%, you will lose 20%.”

This capped downside “made a difference” if the market moved a lot in the wrong direction, he said.

Who can tell?

“You must have a clear view on the euro, and it’s a five-year. I think there are too many moving parts. If you’re bearish on the euro, you can buy an ETF, which would be much simpler,” he said.

“Granted, you don’t have the downside protection. But the problem here is the term. On the short term, you may be able to anticipate a depreciation of the euro. But in five years, nobody knows what will happen to the euro.”

If the view expressed by the note were for the short term, investors would probably be in a better position to have a conviction around the euro.

“If Europe adopts quantitative easing, it will be negative for the euro. If you expect the European Central Bank to push forward in that direction, the result will be a depreciation of the euro. If that’s your view, if you believe that the euro will decline against most major currencies, then this deal makes sense,” he said.

But in general, Balcom avoids currency-linked notes because valuations depend on several macroeconomic factors, such as monetary policy, which makes any outcome all the more difficult to anticipate.

“You face a lot of uncertainty when you try to have a five-year point of view on the euro. I personally wouldn’t buy this note. I don’t have any client that would look at it,” he said.

“It’s a very hard-to-predict trade because everything will depend on what the central banks will do. If you know what the Fed or the European Central Bank will do five years from now, then you have a view and the note could make sense for you.

“The structure has some advantages, but it’s too long and too unpredictable.”

Some pros

Steven Foldes, vice chairman of Evensky & Katz/Foldes Financial Wealth Management, expressed a mixed view as well, liking some elements of the deal but not the underlying bet.

“This is an income deal based on a currency bet,” he said.

“It’s not the type of deal that we would be looking at. But there are a few interesting elements in this structure.

“Each year when the basket is up, you do have the opportunity to collect a 9% annual coupon. If the basket is down, you get a substantial downside protection of up to 90% of your investment.

“In this period of low interest rates, getting a chance of getting a 9% coupon could be very appealing.

“The flipside is that at maturity if the basket is down you will take the first losses up to 10%.”

The cons

Foldes said that the tenor is too long for his investment style.

“To us, five years is a long time. We don’t typically like to go beyond two or three years” he said.

The combination of a long term and the asset class makes the deal less attractive despite the protective structure.

The contingency of the coupon is also a problem, he said.

“The 9% a year is a question mark. Some years you will get 9%; some years you won’t,” he said.

“Over a five-year period, you flip a coin because the currency market is by nature very unpredictable, especially over that period of time.

“Given our ability to predict currencies, which is limited – and I think it’s true for most people, in particular with a basket of currencies – it is very difficult to have a strong opinion. Therefore this deal for us is a series of coin flips.”

A gamble

“Your first coin flip is the coupon. You have the possibility of earning a 9% coupon per year, but would you really get it? And how many times can you be right over the period?” he asked.

Betting that the value of the basket will be positive in five years – in other words, having the conviction that the euro will be lower in five years – is “another coin flip,” he said.

“Your downside is protected, but you could still lose 10% of your capital.

“The worst-case scenario would be you don’t get 9% at any time and you lose 10% at maturity.”

Foldes said that he is not convinced the 90% principal protection is better than having a 10% buffer. The two features serve different purposes.

“This 90% downside protection is good when you need to get protection against a very significant loss, but it won’t protect you from the most likely loss, the first 10% decline. This is not the ordinary buffer, which guarantees you that you won’t lose the first 10%. Here your first 10% is immediately exposed to the downside risk. And there is no big upside here,” he said.

Tough bet

“That type of risk-reward profile is not something that we would be looking at. We use a structured note for the downside protection and for some kind of levered upside. We want both. Here there is the protection but there is no levered upside. All it is is a coupon with no guarantee. We are not all that comfortable with that,” he said.

Currencies are a very volatile and difficult asset class to predict compared to equities, he said.

“With U.S. equities, we have trends that we can observe and use in our analysis, which helps us make decisions. We know that over the past 90 years, U.S. stocks have given a 9% to 10% return per year. With currency there is no trend,” he said.

“When you expect the euro to depreciate against these other currencies for the next five years, you are making a very big bet, which is a very difficult bet.

“Even if you get this absolute protection, this deal limits your upside. You won’t get more than the coupon if you get it. There is no real upside. That’s not how we want to use notes.”

The notes (Cusip: 38147QGV2) priced Sept. 16.

The fee was 2.5%.

Goldman Sachs & Co. was the underwriter.

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