GS Finance’s $5.89 million callable contingent coupon notes on ETFs put coupon at risk

By Emma Trincal

New York, Feb. 11 – GS Finance Corp.’s $5.89 million of callable contingent coupon ETF-linked notes due Jan. 31, 2030 linked to the Energy Select Sector SPDR fund, the Financial Select Sector SPDR fund and the Technology Select Sector SPDR fund present a somewhat new type of principal-protected structure combining a worst of-based contingent coupon payout with a long tenor and issuer call.

The notes will pay a contingent monthly coupon at an annualized rate of 4.4% if each ETF closes at or above its 75% coupon trigger level on the determination date for that period, according to a 424B2 filing with the Securities and Exchange Commission.

The notes may be callable at par plus any contingent coupon due at the issuer’s option on any coupon payment date after six months.

If the notes are not called, the payout will be par plus any coupon due.

“It may be an income replacement for some folks since you have the principal protection,” said Tom Balcom, founder of 1650 Wealth Management.

This adviser understood that the coupon amount reflected the benefit of the full protection, making the product more bond-like compared to other equity-linked notes.

“You’re not getting a very high coupon. But 4.4% is better than the 1.59% yield on the 10-year Treasury.

“Most people need more than that so that’s what you’re getting: a premium over the risk-free rate,” he said.

Three funds

Two of the underlying funds may offer good value, he noted.

“The XLE has been a blood bath over a couple of years,” he said.

He was referring to the Energy Select Sector SPDR fund, which is listed on the NYSE Arca under the ticker “XLE.”

“Companies like Exxon and Chevron are being shunned over fossil fuels. Those big oil companies have been so beaten up for the past couple of years, now may be an opportune time to get in.”

The Financial ETF, which trades on the NYSE Arca under the ticker “XLF,” is vulnerable to low interest rates, he added. The Technology Select Sector SPDR fund (ticker: XLK) on the other hand was rich.

“It’s the XLK that’s the most highly valued in the group. This one could see a pullback,” he said.

Long maturity

Some of the terms of the deal were of concern.

“My issue here is this 10-year term. It might be a little long for my clients.

“Also, you don’t know if and when you’re going to get called. That’s an additional level of uncertainty and you should get a premium for that,” he said.

Investors cannot be called for the first six months. After that, the issuer has the discretion to call the notes monthly.

Asked if the coupon was sufficient to compensate for the call and the worst-of risks, he said: “It’s a head-scratcher. You do have the principal-protection and that’s great. But there’s a 10-year lock-up. Ten years is a very long time. And the chances of being down in 10 years are limited.

“So is it really worth locking your money up for such a long time?

“You are subject to interest rate risk over a long time.

“Goldman is getting cheap financing.

“But as for the investor...I’m not too sure what kind of client would find this appealing.”

Overvalued tech fund

Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, stressed the risk of not getting paid for long periods of time in a pullback scenario. He envisions a negative scenario for at least one of the three funds, based on its valuation.

“You’re exposed to such diverse sectors and not only that, you’re exposed to the tech sector, one of the most overvalued sectors in the U.S. equity market,” Kaplan said.

“The Nasdaq Composite index today adjusted for inflation is either a little bit higher or the same as what it was at its peak in March of 2000,” he added, citing research from John Hussman, president of Hussman Investment Trust, and Robert Shiller, professor of economics at Yale University and co-inventor of the Case-Shiller index.

“You’re buying at a very high level. You may not get back to the initial price level. You may not even get back to the 75% strike,” Kaplan said.

Dot.com bubble

As an example, he said that between its peak in March 2000 and bottom in October 2002, the Nasdaq lost 78% of its value. If the technology sector was to “crash today,” it would take a number of years for prices to move back to the 75% level, he noted.

In 2000 for instance, the Nasdaq peaked at 5,132.52 intraday. It fell by 78.4% when it hit it bottom in October 2002.

Kaplan expects no less of a drop for the tech sector in the near future.

The 75% barrier level applied to the intraday peak of March 2000 would give a price of 3,849.39. The Nasdaq did not retest that level until October 2013, he observed.

“It took more than 13.5 years to get back to 75% of what it had been in March 2000.

Wasting time

Investors in the notes would be exposed to a similar risk investing in the overvalued tech sector today, he said. “Research shows that the Nasdaq is more than twice its historical value and 100% above its fair value. You’re running the risk of a very large drop,” he said.

Since investors receive their principal back subject to credit risk, the market risk is eliminated. But investors should pay attention to the call feature and contingency of payments.

“The risk of getting called in my view is small.

“But you’re taking the risk of not getting paid for 10 years.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The notes (Cusip: 40056XZK5) priced on Jan. 28.

The fee is 3.7%.

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