Goldman’s contingent coupon callable notes tied to two indexes offer more than bond substitute

By Emma Trincal

New York, May 5 – GS Finance Corp.’s 0% callable contingent coupon notes due May 31, 2021 linked to the worse performing of the Russell 2000 index and the S&P 500 index offer investors above-average income return with less risk, said Steve Doucette, financial adviser at Proctor Financial.

The structure offers a worst-of payout tied to two U.S. benchmarks. It has a set of two barriers, one for the coupon payment and the other for the principal repayment at maturity. The notes are callable at par at the discretion of the issuer after one year.

Goldman Sachs Group, Inc. guarantees the notes, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will pay a contingent quarterly coupon at an annual rate of 7.4% if each index closes at or above its coupon barrier level, 60% of its initial index level, on the determination date for that quarter.

The payout at maturity will be par plus the final contingent coupon unless either index finishes below its 50% trigger level, in which case investors will be fully exposed to any losses of the worse performing index.

Fixed-income alternative

“It’s a great fixed-income replacement. Where else are you going to get a 7.4% return in the bond market?” Doucette said.

While the notes do not carry a fixed coupon and lack full principal protection, they leave investors with reasonable chances to earn some income that’s above average while preserving their principal, he said.

“If the index falls more than 40% you just don’t get paid on this quarter. I think you have a pretty good probability of continuing to collect the coupon,” he said.

“You could be knocked out of your coupon for one or a few quarters. But you’ll still get it along the way most of the times.”

Protection

The odds of losing principal after five years due to a decline of more than 50% in either the S&P 500 index or the Russell 2000 from their respective current levels appeared to be very unlikely in his view.

“Chances are you’re linked to the Russell. If the market is down, the Russell is likely to drop more,” he said.

Even in 2008 when both benchmarks fell in the 35% to 37% range, the 40% threshold was not hit, he noted, adding that the market loss happened during a crash over a one-year period not after five years.

“What are the odds you’re going to hit 50% on the date this note matures five years from now? If you add a 7.4% consistent return to your portfolio, the only risk you’re taking really is reinvestment risk,” he said.

Discretionary call

He was referring to the issuer’s call option available after one year, which may be exercised on any quarterly observation date.

“It’s pretty much like the autocall when you think of it. You know that if the market is up, they’ll call it and it’s the same thing that happens with an autocall. It’s not that different,” he said.

“Meanwhile you can lock in a 7.4% coupon on the first year. Your call is a reinvestment risk that you’re running, but you face that in any bond investment.”

Return

The investment was offering even more than income in his view.

“When I look at the forecast for equity markets, 7.5% is freaking huge. It’s an equity-like return you’re adding,” he said.

“I know you can’t say anything is guaranteed. But in my mind, with those 40%, 50% barriers, it is guaranteed. Again the only risk is that they call it away and you may not be able to renew it.

“But the chances of losing money are limited, and where are you going to find that type of return for that type of risk?

“I would put at least a 5% position in that note.”

Equity return

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the notes offered the type of return one would target for an equity portfolio.

“I guess it’s interesting because a 7.4% annual coupon is attractive and is in line with the higher end of equity return expectations,” he said.

“So that’s attractive.

“The part that I would be concerned with is the fact that the issuer at their discretion can call away the notes.

“If they call after the first year, you get 7.45%, which is consistent with those lower expectations. So even if it gets called, it’s not a bad deal.”

Position monitoring

Medeiros said that the call created uncertainty around the duration of the notes, making it more difficult for the adviser to monitor the position.

“I’m not opposed to the call. But I would prefer to have a better idea of the terms of the call because it leaves a void for planning purposes.”

The barrier at maturity helped offset some of the uncertainty.

“I can’t recall a time when over a five year period the market would be down over 50%. Even from a worst-of perspective, the likelihood of piercing the barrier is minimal.”

One year at a time

Assessing the odds for investors to earn the coupon consistently was more difficult.

“The probability of getting paid is an interesting question,” he said.

“The S&P is at a relatively high valuation. You could make the argument for a pullback. Over a short period of time there is definitely the possibility of a correction. But I don’t see a 40% pullback.

Medeiros said he would monitor the note on a year-to-date basis.

“I wouldn’t expect to make 7.4% every year. I can certainly see 7.4% for the first year. Then I would have to revalue this.”

What made the product particularly attractive in his view was the risk-reward.

“I would view this as an equity-like product, something that allows you to make equity-like returns with perhaps not taking all that equity risk.

“It’s an interesting note.”

Goldman Sachs & Co. is the agent.

The notes will price on May 26 and settle on May 31.

The Cusip number is 40054KC38.

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