Goldman Sachs’ callable step-up notes show fair terms, but advisers object to call, credit risk

By Emma Trincal

New York, March 21 – Goldman Sachs Group, Inc.’s callable step-up fixed-rate notes due March 2023 offer “reasonable” rates, but advisers said they would prefer other coupon-bearing options, invoking the issuer’s right to call after one year and the credit risk exposure over seven years.

The coupon is 2.25% for the first three years, stepping up to 3% in March 2019, to 4% in March 2021 and to 5% in March 2022, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par.

The notes will be callable in whole but not in part at par quarterly beginning in March 2017.

Step-up

Carl Kunhardt, wealth adviser at Quest Capital Management, said the call is likely to occur, which reduces the appeal of the product since the best rates are toward the middle and the end of the term.

“The terms are attractive. The 2.25% and 3% rates are reasonable. It becomes sweet at 4% and really attractive at 5%,” he said.

The 4% or 5% rates were especially appealing for Kunhardt as he does not expect rates to rise over time.

“I think we’ll be in a 2%-3% environment for quite some time,” he said.

Call

“However, despite those attractive rates I would go for the outright bond given the choice.

“The 4% and 5% are great, but I don’t think you’ll see them. I’m pretty sure you’ll be called before that. It’s possible you might achieve the 3%, but not the 4% and the 5%.”

Another scenario, which he said is unlikely, would be market rates increasing to the point of making step-up terms less enticing and reducing the odds of a call. Investors in such situation would have to decide whether to hold the notes or to buy something else, he explained.

“It would depend when this happens and how much the rates would rise above 5%,” he said.

“You would have to consider how much of a hit you’re taking on the price when you sell and how much you can earn with the new rates. How long will you have to hold the new security to break even?”

Such calls are hard to make, he said. But “it’s a moot point” since he does not believe in this higher rate scenario.

“I don’t see us getting anywhere close to 3% anytime soon. Rates are going to stay low. It means that the notes will be called. The 4% and 5% coupons are enticing on paper, but it’s not going to happen.”

Capital structure

Aside from interest rates, Kunhardt touched upon credit risk, advancing another objection.

“As a bondholder, you’re first in line if Goldman Sachs goes under. No one anticipates that Goldman will go under, but no one anticipated that Lehman would go under either. You always have to think of credit risk,” he said.

Goldman Sachs Group is rated BBB+ by Standard & Poor’s.

The position of structured notes in the capital structure is different. Investors in those products are non-secured creditors, he noted.

As a result, if the issuer were to default, the holder of a structured note would get paid after the secured debtholders.

“There is a big difference between holding the actual bonds and holding the structured note because with the structured note, you are an unsecured credit. That’s why I would go for Goldman’s straight debt.”

ETF alternative

Michael Kalscheur, financial adviser at Castle Wealth Advisors, expressed concerns about credit risk as well. To counter the risk, he said he prefers to use a bond exchange-trade fund. Some of those allow investors to get exposure to a specific maturity date while diversifying the credit risk across a large number of issues and issuers.

“Credit risk is the number one item on our due diligence list,” he said.

“When we invest in fixed income, we like to diversify our credit exposure. We’re not too keen on having exposure to just one name.”

He said he uses the Guggenheim BulletShares Corporate Bond ETF.

The Guggenheim BulletShares 2023 Corporate Bond ETF comprises nearly 200 constituents. It yields 3.34%.

In comparison, the seven-year step-up notes show a 3.11% yield on average, which would be 3.41% on a compounded basis, he said.

“The difference is slim. If I wanted a 2023 maturity, I would use the ETF to reduce the credit risk. Goldman Sachs is part of the ETF, but it’s only 1.35% of the portfolio. Do I want 100% Goldman Sachs exposure or a 1.35% exposure? That’s the kind of risk-reducing strategy that we like to use,” he said.

Diversification

Kalscheur then compared the step-ups with a Goldman Sachs 5% bullet due March 15, 2023 with a 3.24% yield to maturity.

“With the straight bond I’m not subject to a call, but I’m still exposed to only one name.”

Kalscheur said he takes into account the yield and the amount of credit risk for his analysis.

From a yield standpoint, the difference between the 3.41% yield on the step-ups – assuming the securities are not called – and the 3.34% yield offered by the Guggenheim BulletShares 2023 ETF is minimal.

“Seven basis points is not going to make a difference for most of my clients,” he said.

From a credit perspective, having nearly 200 constituents in the bond fund gives this adviser peace of mind.

“I’m much more comfortable with the Guggenheim. The yield difference doesn’t warrant getting the concentration in one name With the ETF I have full liquidity. There is no call, and that’s important. Most of my clients want to hold the bond to maturity. They understand that a call option can enhance the yield, but they don’t want to be called.

“This step-up note is not a bad deal, but we would prefer the ETF. There are other interest-bearing alternatives that can give you the same or perhaps even a better yield while significantly reducing your individual company risk.”

Goldman Sachs & Co. and Incapital LLC are the agents.

The notes (Cusip: 38148TMA4) are expected to price and settle in March.

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