Goldman Sachs’ CDs tied to Motif Capital National Defense index offer safer, tactical play

By Emma Trincal

New York, Dec. 12 – Goldman Sachs Bank USA’s 0% certificates of deposit due Dec. 26, 2024 linked to the Motif Capital National Defense 7 ER index provide several layers of safety for investors bullish on defense stocks as it comes in a CD wrapper with a low-volatility underlying index.

If the index return is positive, the payout at maturity will be par plus 125% to 135% of the index return, according to a term sheet.

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

The underlying index provides exposure to stocks of certain companies concentrated in the aerospace & defense sector. The index algorithm applies a daily volatility control, which caps volatility at 7%. To do that, it rebalances the portfolio daily between money markets and 10 defense and aerospace stocks. The money markets allocation is 43.52% as of Dec. 11, according to a factsheet published by Solactive, the calculation agent.

Cautious play

“This is a good product for someone who is really risk-averse and worried about a pullback, yet someone who is also bullish on this sector,” said Tom Balcom, founder of 1650 Wealth Management.

The full protection against market declines along with the Federal Deposit Insurance Corp. covering investors against credit risk up to the legal limits are features a conservative investor would value the most, he said.

“Also this is a low volatility portfolio with this huge portion in cash. So there’s risk mitigation at the index level, too.

“This is for the client who is too nervous to allocate directly to the defense ETFs available out there,” he said.

Tactical play

There are good reasons to be bullish on defense stocks, he said.

“You have North Korea these days and a president who is committed to increase defense spending. It might be a tailwind for this sector,” he said.

“It’s a good time to make that type of tactical allocation.”

The performance of the underlying index since 2006 as a hypothetical average is 6.28%. The index was created in June 2016. For investors expecting muted return, this index performance combined with the leverage may be attractive, he noted.

The Motif Capital National Defense 7ER index has occasionally outperformed the S&P 500 index. This year for instance, it is up 20.80% versus 17% for the S&P 500 index through Dec. 7.

In 2008 while the S&P 500 index plummeted by 36.55%, the CDs’ underlying index fell by only 11.36%.

For the other years however, the index underperformed the blue-chip benchmark.

“If you want all the upside you can use the ETFs. This Goldman Sachs CD is for the more anxious type of investor,” he said.

Protection

Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, said that the product at least was taking care of market risk.

“That’s the most important thing. You know you are getting at least what you’ve invested,” he said.

One caveat however was inflation, which he emphasized as being one of the main threats for these types of longer-term investments.

“You may not get all your money back if we adjust for inflation,” he said.

“I think the real risk here is inflation. What you have is an opportunity cost.”

Inflation

Kaplan said that with quantitative easing, low-interest rate policies, inflationary forces are eventually going to be felt sooner than later.

“You could be giving up a lot in terms of returns because inflation could become a significant factor,” he said.

Based on previous cycles such as inflation in late 2007 and the first half of 2008 followed by a recession in 2008-09, Kaplan anticipates a short-term bout of inflation, which will be “interrupted” by a recession sometime in 2019.

“I tend to think inflation will start to pick up again. Once the next recession ends, say sometime in 2019 maybe sooner, inflation will become much more noticeable and that’s going to happen definitely within the next few years when you’re still holding the CDs,” he said.

“With inflation rising, I would be reluctant to give up the potential higher rates I could be getting at a bank.”

Political risk

This reasoning did not take into account the potential returns of the index. But Kaplan said he was skeptical about the long-term potential of the defense sector.

“We’re starting at a high point. Defense stocks have done really well because the political environment was favorable to this sector,” he said.

“With Trump, defense companies are likely to be more funded. But if the Democrats win back the House next year, being exposed to this index may not be as favorable.

“High valuations and a possible change in Congress are serious risks weighing on the sector.”

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

The CDs are expected to price on Dec. 20.

The exact upside participation rate will be set at pricing.

The Cusip number is 38148R4F7.

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