Goldman’s 10%-11% contingent coupon callables on Russell, S&P may offer short-term alpha

By Emma Trincal

New York, Oct. 1 – GS Finance Corp.’s callable contingent coupon notes due Oct. 10, 2023 linked to the lesser performing of the S&P 500 index and the Russell 2000 index can easily outperform a range bound market but investors should be comfortable with the unknown duration as the notes are callable at the discretion of the issuer.

The notes will pay a contingent coupon at an annual rate of 10% to 11% if each index closes at or above its 55% coupon barrier based on a semiannual observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are callable at par on any interest payment date after six months.

The payout at maturity will be par unless either index closes below its 55% trigger level, in which case investors will be fully exposed to any losses of the worse performing index.

Short-term

Carl Kunhardt, wealth advisor at Quest Capital Management, liked the notes as a short-term bet.

“I don’t see these notes as a five year,” he said.

The notes are callable by the issuer, not automatically called if the market is up, he noted.

If the notes had been an autocall, investors would have been called either on the first call date after six months or on the second, making the duration of the investment likely to be less than one year.

But the discretionary call did not make a big difference, he noted.

“It’s going to be a short-term bet because they’re going to call anyway,” he said.

At least one payment

The low barrier increased the chances of getting paid, he noted.

“I don’t see any of the two – S&P or Russell 2000 – falling more than 45% in six months. 45% is a lot. So, you’ll get at least your first coupon and possibly the second,” he said.

He added that the Russell 2000 index was likely to be the worst-performing underlying.

“If you look at volatility of large-cap versus small-cap this is a play on the Russell 2000,” he said.

“But even for small-caps I just don’t see a 45% drop in six months.”

Beating a flat market

The notes happened to fit Kunhardt’s low expectations on equity returns, citing an analyst at a conference who predicted 0% growth over the next five years.

“Through that prism, if you don’t see a big drop, it gives you the opportunity to pick up 5.5% in six months.

“If you think it’s not going up more than zero why not do it?”

The risk of not receiving the coupon was very low.

“Just because you expect zero growth doesn’t mean you expect a negative number. Even if the market drops there is a lot of room to go with a 45% decline. So as long as you’re not called, you’re getting paid,” he said.

Not a bond

Kunhardt said that should he buy the notes, those would be part of his equity allocation.

“Just because it pays a coupon and has a deep protection doesn’t mean it’s a bond. It’s not a bond. It’s a pure equity play,” he said.

“Some investment managers use those notes as fixed-income substitutes. I never agreed with them.

“I consider them equity.

“Forget about the return. Look at the risk and the correlation of the benchmarks and you see that you’re completely on the equity side of the equation.”

Terms are good

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he liked the terms but not the call option.

“I have no problem having a worst-of with two broad-based indexes like these,” he said.

“It’s a great coupon. Double-digit return is what we’re looking for when investing in equity.

“The five-year term fits our long-term requirements, so it’s fine. Besides, this is not really a five-year since it can be called. But if it wasn’t, we would be comfortable with that longer-dated tenor.”

The five-year exposure to credit risk was also not a concern even though Goldman Sachs’ credit default swap rates are the widest among big U.S. banks.

The likelihood of getting paid, absent of an early redemption scenario, was very compelling, he said.

Looking at return tables for the past 70 years, he found a zero probability for any of the two indexes to lose 45% of their value over a five-year rolling period.

Undesirable call

But the nature of the call feature was a “deal-breaker,” he said.

“In general, I’m not a big fan of autocalls. In six months if it gets called you have to do it all over again. It doesn’t work with our long-term investment strategy. It’s more of a short-term trading strategy.

“But at least with the autocall you know when and why the notes are called out.

“When it’s a call at the discretion of the issuer, it’s very difficult to analyze. I’m just very uncomfortable when I don’t know when I’m going to get my money back.

“If the market is down, they can still call me out. That’s the unknown.

“I have a hard time wrapping my arms around this one.

“The structure has a lot of positives. You have a very good chance of outperforming.

“But our clients want to know when they’re going to get their money back.

“That Goldman Sachs and not the market is going to determine when they’ll get their principal back is like a poison pill for us.

“We just have to pass on this.”

The guarantor is Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The notes will price on Wednesday.

The Cusip number is 40056EAK4.

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