GS Finance’s CMS steepeners offer high-yield alternative for inflation hawks

By Emma Trincal

New York, April 14 – GS Finance Corp.’s $17.25 million of callable fixed and floating rate notes due April 9, 2031 caught market participants’ attention given the relatively large size of the issue for a rate-linked issue.

Bets on a steeper yield curve are reemerging in general as investors seeking higher yields and protection against rising prices are showing interest for those new issues, they said.

The GS Finance deal pays a 5% coupon until after April 9, 2022 when interest will equal the difference between the 30-year CMS rate minus the five-year CMS rate multiplied by 3.5, with a floor of 1% and a cap of 8%, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable quarterly.

The notes will be callable quarterly after one year.

The payout at maturity will be par.

Other CMS deals

Separately, GS Finance issued another issue of callable fixed and floating rate notes with the same maturity date for $2.92 million, according to another 424B2 filing with the SEC.

This time, the fixed rate is 7%. After one year, the interest will equal the difference between the 30-year CMS rate minus the five-year CMS rate minus 25 basis points, all multiplied by 7, with a floor of 0% and a cap of 10%.

Both deals feature quarterly interest payments, one-year call protection and full principal protection.

Goldman was not the only issuer to price steepeners. A week before, Citigroup Global Markets Holdings Inc. issued $1.51 million of callable fixed-to-floating rate leveraged CMS spread notes due March 31, 2031, according to a 424B2 filing with the SEC.

The interest rate is 5% for the first year. After that, it will accrue at a rate of 6 times the 30-year CMS rate minus the five-year CMS rate, subject to a maximum of 8% and a floor of 1%. Interest will be payable quarterly.

After one year, the notes will be callable at par on any interest payment date.

The payout at maturity will be par.

Sweet spot

Those three callable fixed and floating rate notes are linked to the same 30-year CMS minus the five-year spread. They’re all 10-year notes. The main differences lie in the coupon rate for the first year, the leverage factor applied to the spread as well as the floor and the cap set for the floating rate.

“When you go to an issuer and ask can you price a 30’s-2’s, the answer is no. The 30’s minus 5’s prices better. They give a higher coupon,” said a distributor.

“We used to see 30’s-2’s but today, without hesitancy, it’s the 30’s-5’s that gets the attention. That’s the better return.”

A bond trader explained why.

“The curve has been steepening very dramatically but it hasn’t been widening evenly in all areas of the curve,” he said.

“By far the biggest move was the 30’s minus the 2’s. The spread between the 30’s and the 5’s hasn’t widened as much. It’s the tightest spread on the curve right now. So, it prices better.

“The issuer has to price based on its risk of having to pay out a higher coupon. That risk is lower on the 30’s-5’s spread since the spread is lower. So, the coupon is higher for the buyer.”

Search for yield

In general, steepeners offer generous yield opportunities, he said.

“When the 30-year is at 2.32% and the five-year at 0.85%, your spread is almost 1.5%. If you lever that up four times, that’s a 6% yield. It’s a lot better than a corporate bond yield from the same issuer,” he explained.

Those steepeners almost always provide what is known as a “teaser” rate, or a guaranteed fixed coupon for at least the first year.

“If you’re getting 5% or 7% as an upfront coupon and then 6% on the floater, that’s a nice source of income,” he said.

“Steepeners are a no-brainer if you anticipate higher rates and inflation, and how not to expect inflation with all the government spending going on?”

The distributor compared the two GS Finance issues. The $17.25 million one was his favorite.

“What people look for is the cap and the floor,” he said.

“The $17 million deal has a 1% floor and an attractive 8% cap. They sold more.”

“That 1% floor is extremely valuable. I’m sure Goldman did better because of the 1% floor. I’m surprised the Citi deal didn’t sell more. It’s still a 1% floor and you have 6x leverage with the same cap, which is actually better.”

The Citigroup deal priced more than a week before GS Finance brought its deals to market.

Footwear

Advisers exploring steepeners as a source of income should also look at other features.

“I would say it’s not about the teaser rate. It’s about leverage, although the leverage you want will reflect your view. If you anticipate a much wider spread, you don’t need as much leverage,” he said.

For the bond trader, investors need to understand the bond market’s bigger picture when buying those products.

“There’s demand for steepeners because long-term yields are moving higher. The curve is not going to get flat,” he said.

“When there’s snow outside, you’re not going to wear sandals. You’re going to buy boots.

“The economy is coming out of a difficult time. Inflation is going to happen. That’s why you’re buying those notes.”

Stocks, yields up

Both the equity and bond markets responded in their own ways to a severe bond sell-off, which pushed the 10-year Treasury yield to 1.77% on March 31.

The progress in vaccination and the government spending signals a strong economic recovery, which has driven stock and bond prices in opposite directions. While the equity market rallied on the hope of a reopening, bond prices fell on inflation fears.

“We had a huge bond sell-off,” said the distributor.

Last week, higher levels of the Producer Price Index continued to fuel inflation concerns but had little impact on the 10-year yield, which stayed at 1.6%.

“The market made its move before the data validated inflation. We hit resistance with the 10-year over 1.75%. But inflation is coming,” the distributor said.

“We had a big and quick move in the bond market. Spreads have widened a lot. People are comfortable the curve is not going to flatten going forward.”

Goldman Sachs Group, Inc. is the guarantor for both GS Finance deals.

Goldman, Sachs & Co. LLC is the underwriter of both issues.

The two deals priced on April 7 and settled on April 9.

The Cusip number for the $17.25 million offering is 40057FXZ2.

The smaller issue’s Cusip number is 40057FU28.

The fee is 2.83% for the $17.25 million issue. The smaller trade carries a 3.30% fee.

Citigroup Global Markets Inc. is the underwriter for the Citigroup offering.

The Citigroup notes, which priced on March 29 and settled on March 31, are guaranteed by Citigroup Inc.

The Cusip number is 17328YYU2 and the fee is 2.25%.

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