Goldman’s 9.45% contingent coupon notes tied to three stocks boost yield with low correlation

By Emma Trincal

New York, Jan. 19 – GS Finance Corp.’s callable contingent coupon notes due Jan. 26, 2022 linked to the common stocks of American Express Co., Nike, Inc. and Microsoft Corp. should appeal to yield-seeking investors who are “comfortable” with the three underlying stocks, said Tim Mortimer, managing director at Future Value Consultants.

The notes will pay a contingent monthly coupon at an annual rate of 9.45% if each stock closes at or above its 60% coupon barrier on the review date for that month, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are callable at par on any interest payment date after six months.

The payout at maturity will be par unless any stock finishes below its 60% barrier level, in which case investors will be exposed to any losses of the worst performing stock.

Low correlation

“With any worst-of on stocks, you need to be reasonably comfortable and familiar with the underlying stocks,” he said.

“The correlations between those three stocks are quite low. This allows the issuer to generate a little bit more yield.”

American Express is a financial stock; Microsoft is part of the technology sector; and Nike falls under the consumer discretionary category.

Future Value Consultants provides stress testing reports on structured notes. According to the report for this product, correlations between the three names are low as they range between 0.48 and 0.54, with 1 being the perfect coefficient of correlation.

Mortimer compared this type of underlying with what issuers have recently been using in other types of worst-of deals.

“Some will add more stocks. There are worst-of with four or even five stocks. But those tend to be names within one sector. This product is slightly different. It’s only three names but it’s three different sectors,” he said.

Risk mitigation

The use of three distinct sectors tends to lower the correlation between the individual stocks.

“That’s how they can get a little bit more coupon,” he said.

But other factors tend to mitigate the risk associated with low correlation between the underliers.

One is the moderate volatility of each stock at around 22%.

“While it’s not low, it’s still relatively reasonable,” he said.

But more importantly, the barrier level is set in a very conservative way, he noted.

“You can afford all stocks to fall by 40%, which is quite a generous limit.

“You don’t need to be bullish with this structure. You just need to be confident that no stock will drop more than 40% and providing that it happens, you get your coupon as long as the issuer has not called the notes.

“It’s quite a wide defensive band.”

Duration

Aside from market risk and credit risk, investors are subject to reinvestment risk as the notes can be called after six months. However, a six-month no-call period helps by offering a minimum contingent coupon worth six payments.

“You wouldn’t want to get 0.78% after just one month. It would be quite unattractive. Most callable products have some sort of protection for an initial period of time,” he said.

The four-year term is longer than average. Last year’s average tenor for callable contingent coupon notes was 2.72 years, according to data compiled by Prospect News.

However, the duration of the note will be approximately twice shorter given the call option, he said, based on the report.

It won’t be 100%

Each of Future Value Consultants’ stress test reports provides a series of tables detailing the potential outcomes under various market scenarios.

One of those tables, called capital performance tests, displays the probability of the three outcomes for this product. Those are: return more than capital; return exactly capital; and return less than capital.

Regardless of the market scenario – neutral, bullish, bearish, volatile and less volatile, the second outcome is impossible, he noted. The probability of getting “exactly capital,” is zero, the table shows.

“When you’re called you get at least one coupon. And if you’re not called, you either breach the barrier in which case you get less than capital or you get your last coupon,” he said.

“There is no way to get just your capital back.”

High chances of winning

The probability of getting more than capital either through the early redemption scenario or at maturity is 77% in a neutral market environment, the table showed. Even under the bear scenario, the chances are 57%.

“It’s a significant probability. Even in a bearish market, the chances of making money are pretty good,” he said.

The simulation model uses a neutral scenario, which is risk neutral and based on how the banks price the options.

In addition, it offers four market assumptions which are based on hypothetical growth of the underlying and its volatility. These are designed to help investors with a view have a better idea of their potential performance and probabilities of outcome if they are correct. Investors interested in this product may have a bias toward a low volatility outlook for instance.

First call

The probability of a call on the first call date is 26.56%, according to another table called “product specific tests,” in the neutral scenario. The greater the chances of a call, especially early on, the more likely investors will get paid a return in excess of their principal.

Mortimer went back to the capital performance tests table to analyze the average payoffs displayed for each outcome. In the “more than capital” outcome, which occurs 77% of the time, their average payoff in a neutral market would be 113.8%.

“Bear in mind that you wouldn’t necessarily get all the coupons. Also bear in mind that this payoff is a function of how long the product can run without being called,” he said.

If the notes are called on the first call date in six months, the return would only be 4.72%.

“This is why the bull scenario shows a lower payoff,” he said. He was referring to a 114.2% average payoff for the bull scenario.

“You get less because the money is coming back quicker. You get called faster and the product’s duration will be lower,” he said.

This is consistent with the 34.4% probability, in a bull market, of being called on the first date, six months after pricing versus 26.11% in the neutral scenario, according to the product specific tests.

The note will do best in the less volatile market scenario, he noted, based on the report. It is in this environment that the chances of getting a return are the greatest, the probability of a loss the lowest and the average payoff the highest at 115.6%.

One-year charm

Another table, the scorecard, which reveals the probability of calls by call dates, suggests that if the notes are called on point 7, investors will have received all their monthly payments throughout that first year. The first call point is after six months. The next six call points are monthly observations until the first-year anniversary.

There is a 43% probability to see the notes called either on the first date after six months or on any of the six following months. The probability of a call on the first anniversary of the notes is 1.53%. But the payoff in this case will be 9.5%.

“When you get called at that point you have received all your coupons for that first year,” he said.

The notes are not very likely to mature. This outcome will occur only 14% of the time, according to the scorecard. But in this scenario, the average payoff is 132%.

“That’s 8% a year, almost the full payoff, so you get most of the coupons,” he noted, adding that the low coupon barrier contributed to give noteholders a chance to accumulate cash flow through the life of the product.

Income-oriented

In conclusion, Mortimer said the notes are designed for income investors who have some understanding of the risks associated with the individual underlying stocks. As with any stocks used in structured notes, there is risk.

But investors are well compensated for it.

“It does pay a very high coupon,” he said.

“It’s linked to three major stocks that are uncorrelated.

“But making this work won’t require much. You just need to avoid having one of the stocks lose 40% in order to keep the coupon going and get your capital returned.

“It’s quite a defensive structure and it will provide a positive return even if the stock goes down,” he said.

“Being able to make money more than three-quarters of the time seems quite reasonable.”

The guarantor is Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The notes will price on Jan. 19 and settle on Jan. 26.

The Cusip number is 40055AFA0.

© 2015 Prospect News.
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