GS Finance shows unusual worst-of structure with fixed rate, no autocall on Russell, ETF

By Emma Trincal

New York, April 20 – GS Finance Corp.’s 5.1204% fixed coupon underlier-linked notes linked to the Russell 2000 index and the iShares MSCI EAFE exchange-traded fund represent an original form of worst-of, closer to a traditional reverse convertible than the widely seen autocallable contingent coupon worst-of, a market participant said.

The notes, expected to have a term of 18 months, will pay a fixed coupon of 5.12% a year payable monthly.

If the return of each underlier is greater than or equal to negative 20%, the payout at maturity will be par.

If either underlier falls by more than 20%, investors will lose 1.25% for every 1% decline of the lesser performing underlier beyond 20%.

Reverse convertible

“This is a reverse convertible, but not your typical reverse convertible,” the market participant said.

“First this one is not autocallable. And second it’s done with a worst-of underlying.

“I haven’t seen a lot of worst-of with a fixed rate. That said, it’s not innovation. It’s just a different way to assemble the parts together.

“Worst-of are extremely popular right now. I’m not surprised they’re doing it that way. You may have had an investor requiring a guaranteed coupon.”

More predictable

Eliminating the contingency of the coupon and the automatic call was not expected to boost the coupon.

“You use the contingency and call feature to extract more premium. So my guess is that someone needed the fixed rate probably because he had no choice,” he said.

“It could be an investor’s mandate. Some investors, especially institutional investors, are not allowed to use contingent coupons.

“This is a pure income play. They have removed a lot of the uncertainty...and that is you know how long you’ll be holding the notes for, you know how much income you’re going to get.”

The underlying exposure remained a wild card as investors do not know in advance which of the two underliers will perform the worst.

Buffer

The 20% geared buffer was apparently conservative.

“You may wonder: how can they price such a strong buffer?

“But they’re only paying you for 18 months,” he said. “It’s not a whole lot of coupons. Anytime you sell an option, the shorter the tenor, the more premium you get per annum.”

This is one of the reasons reverse convertibles have traditionally been short-term notes, he added.

“The geared buffer also helps of course,” he said. “You’re selling the risk against the principal.

“If you gear it, your investment can go to zero. If the investor doesn’t mind, you might as well sell the possibility of it and get a higher coupon. And that’s what they do.”

Yield

In conclusion, this market participant believed that the notes were adequately priced.

“I think the coupon is not as low as it appears to be,” he said.

“It’s all relative. For what you get it’s not bad.

“If you consider that it’s a fixed rate, that you don’t have an autocall, I think it’s a pretty good pick up actually.

“It’s a pretty reasonable high-yield trade.

“It comes at a price: you’re selling a worst-of; you’re gearing the buffer.

“But it’s a reasonable proposition for an income investor.”

Risk-return

A financial adviser disagreed.

“I don’t like the return,” he said.

“There’s a buffer. But the best you can do is 5.12%. You’re likely to get the exposure to the Russell, which has been screaming up. The EAFE has been relatively flat.

“And with 1.25 levered in either these indices there is a huge potential downside with a potential gain of 5.12% over 18 months.

“You’re really giving up the market upside for the protection.”

The downside protection was not negligible he conceded.

“It takes a long way before you eat up that buffer. It’s a decent protection,” he said.

“But who would want this type of return?”

Allocation

Typically risk-averse investors would not mind the lower return in exchange for more safety.

But Doucette did not think the notes would even appeal to conservative investors.

“Anytime you tell a conservative investor here’s a fixed rate and it’s well above Treasuries they’re happy.

“But if you say it’s fully exposed to the downside, they’re not as happy.

“This is an equity substitute for conservative investors. It’d be really tough to find a place for it.”

The notes are guaranteed by Goldman Sachs Group, Inc.

The return of each underlier will be measured from the initial levels set on April 18, which are 1,361.894 for the index and $61.69 for the ETF.

Goldman Sachs & Co. is the underwriter.

The Cusip number is 40054L7A6.

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