Goldman’s callable range accrual notes on Russell show poor risk-return tradeoff, sources say

By Emma Trincal

New York, Sept. 8 – GS Finance Corp.’s callable buffered monthly range accrual notes due Sept. 30, 2021 linked to the Russell 2000 index pay a variable coupon based on how often the equity price moves within a range, a technique also used with rates or currencies to generate return. But buysiders said the risk in this note is too high despite the buffer. They based their view on the coupon rate, the maturity, the amount of principal at risk and on the impact on returns of an early redemption at the discretion of the issuer.

The notes are guaranteed by Goldman Sachs Group, Inc., according to a 424B2 filing with the Securities and Exchange Commission.

Interest will accrue at an annualized rate of 5% for each day that the index closes at or above the trigger level, 80% of the initial index level. Interest will be payable monthly.

The payout at maturity will be par unless the index falls by more than 20%, in which case investors will be exposed to any losses beyond the buffer.

The notes will be callable at par on any interest payment date after one year.

Yield hunt continues

The rationale behind the notes was income, said Steve Doucette, financial adviser at Proctor Financial, who buys income-generating structured notes for his clients but rather than range accrual, uses mostly contingent coupon notes.

“This is about yield. Somebody is looking for a coupon that pays more than Treasuries,” he said.

The five-year Treasury yields 1.18%.

“You may not collect the total return. But the buffer and the barrier seem pretty good to collect some coupon.”

Doucette said he was more concerned by the risk of losing money and how the call option, if exercised by the issuer, may dampen the chances of making a worthwhile return.

“The scary part is that you collect 5% a year, best case scenario. That’s 25% at maturity, which is very unlikely because you’re not going to get the entire coupon. Meanwhile 80% of your principal is at risk,” he said.

Call feature eyed

The discretionary call may reduce the benefit of the note, he added.

“Imagine the market is up: you collect the coupon. But then they call it and you don’t collect anymore,” he said.

Another negative scenario would be a market turnaround following a market downturn.

“The market is down and comes back. You haven’t collected the coupon when the market was down. And now the note is called. So when you can finally collect something, the note is gone.”

These assumptions are based on what issuers usually consider when they decide to call notes.

The prospectus identified the factors making the issuer “more likely” to call the notes.

The level of the index price – if it stays above the barrier threshold – will increase the likelihood of a call, the prospectus noted.

Other factors include declining interest rates and tighter credit spreads.

Worst-of format

Doucette compared this range accrual note with other income products. He had in mind autocallable contingent coupon worst-of, which he is accustomed to buy.

“We love these things. They typically give you a low barrier at maturity in the 40% or 50% level and the chances of collecting the coupon are pretty high,” he said.

“Now that the market is up, we’re a bit more cautious. There is more risk. Even with a low barrier, if the market is down 40%, you’re through the barrier and you lose money.”

At the same time, the risk-reward seen with autocallable contingent coupon worst-of products was more favorable to investors, he said.

“You’re getting much higher returns. Those coupons can go from 8% to 12% a year. You may lose some money, but if you get 12% on the first year, 24% on the second year and so on, you still collected a pretty substantial coupon,” he said.

Risk-reward

The same could not be said about the Goldman Sachs notes.

“The risk outweighs the reward,” he said. Credit risk exposure over a five-year period, not receiving the coupon and the risk of losing principal at maturity were cited as the most obvious drawbacks.

“The early redemption is also a risk,” he said.

“The idea of not getting the coupon because the market declines and then getting called because the market is up finally so you lose your only chance of getting paid, this is not particularly appealing.

“If they didn’t have that call provision... that might work out for you. The market might go down and if it’s coming back you still get something. But the call gets in the way.”

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the hybrid and complex structure made the asset allocation decision a difficult one for advisers.

“There are a lot of moving parts. I’m not in favor of notes that have too many triggers or mechanisms built in,” he said.

The issuer probably intended to offer the product to fixed-income investors, but it was not clear whether the risk fit with those types of clients. If designed for equity portfolios, the risk-adjusted return was not adequate, he said.

Variable income

“The proposed coupon is really a variable coupon. I’m not quite sure how that would fit into the fixed-income portion of a portfolio,” he said.

“If I’m looking for a fixed-income substitute, I want to understand what my income is.

“Somebody looking for a monthly income is probably not looking for a variable monthly income. You want a consistent monthly income.

“And this one is locked in for five years, which is a long time.”

Not equity

“There’s no upside participation. You’re getting 5% or even less. You’re taking equity risk for a fixed-income return. That’s not a great risk-return trade off.

“I’m not even mentioning the call, which is an entirely different thing to consider.

As an alternative, Medeiros said there was in the market a number of large-cap stocks, which offered dividend yields “close to” the coupon paid on the notes with potential upside appreciation.

“I’m not sure I like this particular note. I don’t really see the benefit of it,” he said.

Goldman Sachs & Co. is the agent.

The notes will price Sept. 28.

The Cusip number is 40054KJH0.

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