Goldman Sachs’ capped CDs tied to Euro Stoxx 50 target risk-averse, nervous investors

By Emma Trincal

New York, July 11 – Goldman Sachs Bank USA’s 0% certificates of deposit due July 30, 2024 linked to the Euro Stoxx 50 index offer conservative investors full exposure to market gains up to a cap with 100% protection on the downside. But risks remain given the length of the investment and the taxation of zero-coupon bonds, advisers said.

If the index return is positive, the payout at maturity will be par plus the index return, subject to an 85% to 100% cap and will be set at pricing, according to a term sheet.

If the index return is zero or negative, the payout will be par.

Nervous Nellie

“For a client nervous about the market being pretty toppish, and many clients feel that way right now, this would make sense,” said Tom Balcom, founder of 1650 Wealth Management.

“It gives you exposure to the Euro Stoxx with limited risk.

“For a nervous Nellie who’s worried about the all-time highs, it’s an option.”

In exchange for the protection investors have to hold the notes for seven years and forgo the dividends paid by the companies composing the index. The Euro Stoxx 50 index yields 1.53%.

“They have to give up something. It’s a long tenor. Forecasting the European stock market in seven years is impossible. And you give up more than 10% in dividends,” he said.

“But that’s how you get the 100% protection.”

Doubling up

Balcom said the cap level was reasonable.

“It’s the rule of 72. You double your money in seven years,” he said.

The so-called “rule of 72” determines how many years it will take for investors to double their capital based on a fixed rate of return. The number 72 is divided by the rate of return to give the number of years. In this example, the rate of return would be approximately 10% if the cap was at its maximum level of 100%.

“This note is desirable for the very risk-averse client, people who are afraid of volatility,” he said.

But as an adviser, Balcom said he would have to explain some of the risks associated with this product.

“Even if it’s 100% protected, whenever you’re tying up your money for seven years you have some risks,” he said.

Phantom income

The main risk in his view was related to taxes. Fully protected notes are not taxed in the same manner as principal at risk securities, he explained.

Principal-protected notes are built on a zero coupon bond. Investors do not receive any interest or gain until maturity. Yet each year, they must report an Original Issue Discount (OID) tax.

“It’s a form of income tax. You don’t collect any income. But you do have to pay taxes on it every year.

That’s why they call it phantom income. It’s a zero. There is no coupon. All you get if you get anything is at maturity,” he said.

“If the client makes no money on the investment but pay taxes all the way, it’s a problem. You lose money along the way. This is tricky and it has to be explained to the client.”

While foregoing dividends and holding the notes for a long period of time were part of the natural tradeoff required to obtain 100% downside protection, the “phantom” income tax was a harder sale for clients, unless the market-linked CD was bought into a tax-exempt account, he said.

Bear coming

Steven Jon Kaplan, founder and portfolio manager at TrueContratian Investments, said having protection against market declines is always good. But he had two major objections regarding the product, both related to time.

The first one was timing; the second, duration.

On the first point, timing was “bad” in his view as he believes we are heading toward a bear market.

“Within the next two years, I think we could see a drop of more than 50%,” he said.

The bear market of 2007-09 saw a 57% market fall between October 2007 and March 2009, he noted in reference to the domestic stock market.

He brought up valuation figures about the U.S. markets.

Price-to-book ratios are “actually higher now” than they were in 2007, he said.

The Nasdaq is more than twice higher what it was at the top of 2007.

Finally, he noted that the forward P/E for the Russell 2000 index was 26 in July 2007 and is now at 33, he added.

A bear market in the United States would have a global impact, including in the European market.

“We have a more dangerous, overpriced market now than we had back in 2007. Just in virtue of an ordinary regression to the mean, a big drop is coming,” he said.

Because he believes a bear market is likely to be felt within the next two years, investing in a seven-year note at this point made little sense, he said.

“If you had invested at the end of 2008 you would have done better than at the end of 2007,” he said.

“I would just wait. The timing isn’t right here.”

Loss of real return

Kaplan’s second preoccupation was with inflation.

“Inflation right now is low. Rates are low. People assume rates are always going to be low. But at some point interest rates are going to be much higher,” he said.

“If your investment does nothing at the end of seven years and inflation picks up, you’ll end up losing money.”

“You could be losing half of your investment in two years due to a bear market. Then it would go up again, but since you lost so much, you end up going sideways.

The result in his hypothetical scenario would be investors holding the note for seven years and getting no positive return.

“Just because you’re getting back your principal doesn’t mean you didn’t lose money. Inflation is a hidden loss. The time you spent earning nothing is a loss,” he said.

“I’m not seeing much value in this.”

Goldman Sachs & Co. is the underwriter. Incapital LLC is the distributor.

The CDs are expected to price on July 25.

The Cusip number is 38148DWJ9.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.