Goldman's $20 million CMS rate-linked notes offer yield, protection for long-term bet on rates

By Emma Trincal

New York, March 27 - Agents are bringing to market more interest rate-linked notes in an effort to respond to investors' anticipations of rising long-term rates, sources said, commenting on some recent deals linked to Constant Maturity Swap rates.

An example was last week's $20 million of 15-year callable quarterly CMS spread notes due March 27, 2028 priced by Goldman Sachs Group, Inc. They are linked to the 30-year Constant Maturity Swap rate and the five-year CMS rate, according to a 424B2 filing with the Securities and Exchange Commission.

The interest rate is 9.25% during the first year. After that, the coupon will be four times the spread of the 30-year CMS rate over the five-year CMS rate minus 20 basis points, subject to a maximum rate of 9.25% and a minimum rate of zero. Interest is payable quarterly.

The payout at maturity will be par.

The notes are callable in whole at par plus accrued interest on any interest payment date beginning Sept. 27.

Institutional demand

Earlier in the week, Goldman Sachs priced $10.5 million of callable quarterly CMS spread notes due March 22, 2028 linked to the 30-year and five-year CMS rates, but with a 9% interest rate for the first year. The call features and the 9.25% maximum rate were the same.

Separately, Royal Bank of Canada priced $10 million of redeemable leveraged steepener notes due March 27, 2033 linked to the 30-year CMS rate and the two-year CMS rate, according to a 424B2 filing with the SEC.

The coupon is 6% for the first year. After that, interest will be equal to four times the spread of the 30-year CMS rate over the two-year CMS rate minus 50 basis points. Interest is payable semiannually.

The payout at maturity will be par.

The notes will be callable at par on Sept. 27 and March 27 of the years 2014, 2019, 2024 and 2029.

RBC Capital Markets, LLC was the agent.

"We see institutional interest in the structure," a sellsider said about the steepeners, which pay a coupon based on the spread between rates in two parts of the curve.

"We've seen higher rates for most of the month. With the employment picture clearing up, people are expecting an end of the stimulus program sooner [rather] than later, taking a view on a steeper yield curve," he said.

30-5 versus 30-2

A rates structurer explained why the market may see more notes linked to the spread of the 30-year CMS rate over the five-year CMS versus the spread of the 30-year CMS rate over the two-year CMS rate, which he called "30-5" and "30-2," respectively.

"Clients are switching from 30-2 to 30-5 steepeners because the pricing on the 30-2 isn't there right now, the optics don't work," he said.

He said that when the Street was pricing the "30-2" steepeners earlier this year, the "curve was much flatter" at about 200 basis points. "Now it's about 260 bps, so it's steeper, it's more expensive to do."

From November when the 30-year CMS rate over the two-year CMS rate was at only 212 bps to mid-March when the spread reached a 270 bps high, "we've seen substantial steepening," he said.

In contrast, "the 30-5 is much better for pricing," he noted, pointing to a spread of 202 bps currently.

"People are anticipating higher rates. There's a lot of talk about the Fed exit strategy," he said.

"A lot of investors can't buy principal-at-risk and they still need the yield.

"Those products are the only area where you can get an 8% rate with principal protection. I think that's why we're seeing more demand for it. For a growing number of investors, those steepeners are seen as the deals that offer the best risk return," he said.

Coupon at risk

Looking at Goldman Sachs' $20 million 15-year notes tied to four times the 30-year/five-year CMS rate spread minus 20 bps with a 9.25% first-year coupon and callable quarterly after six months, a market participant said that the real risk for investors was not the call but the possibility of not receiving any interest for a long period of time given the variable coupon.

The notes were designed for conservative investors, but risks related to the duration were not negligible, he said.

"This is a pure rate deal. A CMS 30-5 is for someone who doesn't want to have any equity contingency," he said.

He was referring to other types of steepeners that pay a coupon based not only on the yield curve but on the number of days an equity benchmark stays above a specified barrier.

"Your principal is protected. But you're risking 14 years of coupon. There is no guarantee," he said.

"This is why you're getting paid a high fixed rate of 9.25% during the first year.

"If you get called, it's not the worst thing that can happen to you. Besides, the call is not automatic. Even if the curve gets steeper, the bank may not call you because the curve could go back down and then you're stuck for 14 years and they don't have to pay you any coupon, which would be the best outcome for them. By not calling you, the bank has that possibility. It's an option they can exercise on any quarter.

"If they do call you, it's actually not a bad thing. It means you won. They don't want to pay you anymore. The rates have gotten too high. They just pay you off.

"So you shouldn't be worried about the call. It's the other way around. It's more being stuck for 14 years without any coupon that you should be worried about.

"Those deals are being put together because there is demand for headline coupons and full principal protection. But in exchange, you can get locked in for 15, 20 years. There's risk in that."

Goldman Sachs & Co. was the underwriter.

The notes (Cusip: 38141GQW7) priced March 22.

The fee was 2.962%.

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