GS Finance’s $24.89 million digital notes on CMS rate offer unusual way to boost return

By Emma Trincal

New York, Aug. 28 – GS Finance Corp.’s $24.89 million of 0% digital notes due Sept. 29, 2020 linked to the 10-year Constant Maturity Swap rate use a digital payout with a deep barrier linked to a rate, an original way to boost yield. But sources said the trade is, if not risky, at least contrarian in this declining rate environment.

“It’s not for everyone,” a trader said.

If the swap rate finishes at or above its initial value or falls by up to 50%, the payout at maturity will be par plus the contingent digital return, 13.1%, according to a 424B2 filing with the Securities and Exchange Commission.

If the swap rate falls by more than 50%, investors will lose 1% for every 1% that the final rate is less than the initial rate.

Since investors make money when the rates do not drop more than 50%, investors must have a neutral or bearish view.

Rates go south

“In the quest to get more yield, people are getting more and more creative. The 13.1% return is very attractive. But at the same time, you’re putting a lot of principal at risk,” this trader said.

A 50% downside barrier on an equity index would seem low. But it’s a different story with the 10-year swap rate at a time when rates are tumbling, he said.

On Wednesday, the10-year CMS rate was at 1.36%, already 6.2% lower than a week before. The deal priced on Aug. 21 with the swap rate at 1.45%.

During the past six months, the trader said, the 10-year CMS rate hit a high of 3.29%.

“And the low, here we are. 1.36%. We just did it today.

“That’s a 200 basis points drop. That’s your 50% barrier breach right there.

“So yes, it can easily go down.”

Inverted yield curve

For the second time since last week, the spread between the two-year and the 10-year Treasury notes briefly inverted with the two-year yielding 1.50%, above the 10-year yield of 1.45%. Meanwhile the 30-year bond fell to its lowest level on record.

“The market is ahead of the Fed,” this trader said.

“The 10-year is up in part because there is no inflation. I don’t believe that it’s out of fear of a recession. They talk about the inverted yield curve signaling a recession day after day in the news. You can’t get away from the news.”

Instead, the trader sees in the lower bond yields the simple mechanism of the market at play with global investors bidding for the highest-yielding government bonds.

“People are simply buying the 10-year because they’re looking at where to get a return. Our 10-year bond is at 1.46% right now. In Germany it’s at minus 0.72% and in France, minus 0.44%. Where do you go? It’s a financial decision. People make that financial decision on a global scale every day. Ultimately, yields get compressed.”

Hybrid securities

Given how fast the 10-year CMS rate can decline – from its high last fall to today’s low, the drop is 59% – this trader concluded that the deal was perhaps too risky.

“There’s too much risk. Rates can go to zero. They can also go negative as we see all around the world.

“Once you breach that 50% barrier you lose at least half of your principal,” he said.

“In a normal world you have stocks and bonds. People have a little bit of both in their portfolios. The problem arises when you breach the line between stocks and bonds. It’s when you get those hybrid securities.

“This note looks and smells like a bond. But it’s equity.

“If you have to play equity, why not use a simple autocall on one or two U.S. indices. Get yourself a 65% barrier, a 7% contingent coupon and the autocall. It’s far less risky,” he said.

No coupon

Another concern was how to ensure investors understand that the notes are not really a plain-vanilla bond.

“Clients can be very smart. But they’re professionals. They’re lawyers, doctors or accountants. They’re busy doing other things,” he said.

“You sell them this product. Three months later, they call: where’s my income? And you say: you don’t get this until the end of the year. Maybe.”

“While it’s the job of the broker to explain all the details of the deal, the fact that it’s linked to something people know little about, a swap rate and not your typical S&P 500, could be source of confusion, he said.

“It may be OK for an institutional investor. But I’m not sure it’s appropriate for an individual investor.”

It can happen

A market participant said he liked the coupon. But he also stressed the risks associated with the trade.

“It’s not bad. 13.1% on 13 months. You get 1% a month,” he said.

“But the moves have been violent.

“You’re betting against rates going negative. That’s tricky.”

From April when the 10-year CMS was at 2.41%, the rate has nearly dropped 50%.

“Going 50% lower is easy. It sure feels like it. Nothing is impossible in this market anymore.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The notes (Cusip: 40056X5M4) settled on Monday.

The fee is 1.1%.

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