Goldman’s seven-year autocallables on Motif National Defense show full protection, no cap

By Emma Trincal

New York, March 27 – GS Finance Corp.’s 0% autocallable notes due April 28, 2025 linked to the Motif Capital National Defense 7 ER index offer an unusual payout combining a step-up autocallable with a double-digit call premium if the notes are called and, if they are not, unlimited one-to-one participation on the upside and full protection on the downside.

The notes will be called at par plus an annual call return of 12% if the index closes at or above its call level on any annual call observation date. The call level will be 105% of the initial level for the first call observation date, stepping up by 500 basis points on each subsequent year to a final call level of 130% of the initial level for the sixth observation date on April 12, 2024, according to a 424B2 filing with the Securities and Exchange Commission.

Defense play

The underlying index, created in June 2016 by Motif Capital Management, Inc., comprises stocks of companies that derive at least 10% of their revenue from defense-related sales that may benefit from increased defense-related spending by U.S. and foreign governments, according to the prospectus.

Top holdings include: the Boeing Co.; Northrop Grumman Corp.; Raytheon Co.; Lockheed Martin Corp.; and General Dynamics Corp.

Solid premium

While the call levels step up each year, investors get compensated and have a chance to outperform the index.

For instance, if on the first call date the index is up 5%, investors receiving the 12% premium would do significantly better than the underlying.

On the second year, they may get 24% if the index is up 10% etc.

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, who is bullish on defense stocks, was not convinced that investors in the notes would be well-positioned to benefit from the sector appreciation.

Short-term bear

“The best scenario is if the sector sells off and then recovers. If you’re bearish short-term and bullish long-term you’re likely to benefit from the notes. If that’s your view, you can appreciate the principal protection,” he said.

“I just don’t think it makes sense. There is a very narrow band where you can benefit from this. And it doesn’t align with my thinking of the sector.”

Cap

Chisholm said he is bullish short-term.

“The most likely scenario is that you get called on the first year with 12%. Five percent is not a high hurdle given the U.S. spending on defense.”

He was referring to the 105% call level on the first observation date.

“You get called with 12% after one year. I believe there is a potential for the sector to trend much higher short-term. Why would I limit my upside?” he said.

Principal-protection

If the notes are not called, investors are fully protected against market risk. Yet they still have the credit risk exposure for seven years. For Chisholm, an even greater disadvantage is having one’s capital tied up.

“You could end up with nothing at maturity if the notes aren’t called, he said.

“Even the principal protection is not that appealing. I don’t think the sector needs it.”

The need for principal-protection may even be lower due to the nature of the index, which is designed to reduce the volatility of the portfolio, he noted. The algorithm does that by rebalancing the money market position.

“Historically, a very significant portion (up to approximately 92%) of the index’s exposure consistently has been allocated to the money market position,” states the prospectus.

Tenor

Given the moderate value of the full protection, Chisholm was inclined to think that the notes were too long.

“It may not necessarily be a seven-year note because you are likely to get called. But it still has the potential to be that long. You have an illiquid investment. That’s a problem in itself.

“I’d be much more comfortable buying the [exchange-traded fund]. If the sector turns for the worst I would have the liquidity,” he said.

Step-up

Jonathan Tiemann, president of Tiemann Investment Advisors, also pointed to the “lack of liquidity” of the notes.

“You might be stuck for a long time. Worst case scenario, you lose nothing but you got nothing after seven years,” he said.

Tiemann said that he did not see a reason to prefer the notes to owning the stocks outright.

“There is principal-protection but I can do that myself and be liquid,” he said.

The call levels stepping up made sense from a pricing standpoint but would have to be explained to a client.

“The fact that the threshold moves up is how you pay for the increase in payout,” he said.

“But I don’t think the complexity really buys me anything.”

Duration

The uncertain duration of the investment was another disadvantage.

“I don’t know when I’m going to see some liquidity.

“If I have poor liquidity, I want to be invested in an instrument where it’s a natural feature, like private equity.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. is the agent.

The notes will price on April 12 and settle on April 17.

The Cusip number is 40055ATK3.

© 2015 Prospect News.
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