Goldman’s callable contingent coupon notes linked to index, fund have sources sitting on fence

By Emma Trincal

New York, April 10 – Buysiders were torn about the value of GS Finance Corp.’s callable contingent coupon index-linked notes due April 28, 2020 linked to the lesser performing of the S&P 500 index and the SPDR S&P Oil & Gas Exploration & Production exchange-traded fund.

They saw pros and cons in the structure, which made it difficult to have a clear view on the product.

The notes will pay a contingent quarterly coupon at an annualized rate of 10% to 11% if each component closes at or above its 70% coupon barrier on the valuation date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are callable at par plus any contingent coupon due on any interest payment date from October 2017 to January 2020.

The payout at maturity will be par plus the contingent coupon unless either component finishes below its 70% trigger level, in which case investors will be fully exposed to the losses of the worse-performing component.

“I sort of like it, but I would have a hard time making up my mind. It’s not totally clear if it makes sense or not,” said Clemens Kownatzki, independent currency and options trader.

Barrier

He started by mentioning the positive aspects of the deal.

The 30% barrier seems “fair,” he said.

“It’s actually a pretty large barrier, even for the oil explorers, and it’s unlikely that the S&P [500] would go down 30% in three years.”

Valuations are favorable for the oil fund.

Low ETF price

“Oil explorers are trading very low right now,” he said about the ETF, which he also referred to as “XOP,” its ticker symbol on the NYSE Arca.

“XOP was as high as $84 in the last three years. Then it dropped to $24 in January 2016. That’s a 71% drop. We then bounced back to nearly $38 today. So there is more room for upside than downside, at least from a valuation standpoint.”

Policies, coupon

Another factor that may work to the advantage of investors by reducing the chances of a barrier breach is policy changes put in place by President Donald Trump.

“There’s a chance that this administration may continue to eliminate a number of environmental regulations, which in theory should make oil exploration a more viable business as the cost of drilling could drop. You could find a rationale that this sector would be performing well,” he said.

Finally, the amount of coupon – at least 10% a year – is attractive.

“It’s also something you can get fairly easily as long as none of those two assets falls by more than 30%.”

If the barrier were to be breached, investors would not incur “negative cash flow,” he said. They would merely miss a quarterly coupon payout.

Volatile underlying

But Kownatzki was able to find just as many points that he considered to be red flags.

The first risk lies with the SPDR S&P Oil & Gas Exploration & Production ETF, which is three times as volatile as the S&P 500 index.

“Looking at the notes it’s clear to me that the concern on the downside comes from the oil explorers,” he said.

“Oil prices are unpredictable. There is always upside potential under geopolitical pressure. We just saw that with the strike in Syria,” he said.

The “other side of the coin,” he said, is fracking, a technology that adds more supply, worsening the global oil glut and putting oil prices under more pressure.

Bear lurking

Analyzing the other underlier, the S&P 500, he also expressed a mixed view.

The S&P 500 currently trades at 2,360. From a technical standpoint, a 30% decline would take the benchmark to 1,650, which is below a “strong” resistance level seen at 1,800, he observed.

But from a valuation and market cycle standpoint, it is possible to envision this level of price decline.

“We really don’t know. It’s possible that we may be entering into a bear market, which would trigger the barrier,” he said.

“We haven’t seen any bear market in the last eight years. From a time perspective, the three-year term raises some issues. A major downturn could very well happen within that timeframe.”

While a drop in the ETF share price is possible given the volatility of the fund, the probability of a bear market occurring within the next three years is higher given the high valuations of U.S. stocks and the aging bull market, he said.

Hedge

“You have potentially unlimited risk on the downside. The upside is capped. From a normal investor’s perspective, why would you want to cap the upside with unlimited downside?”

The “normal” way to buy the note would be to hedge it, he said.

“In theory, this note could be hedged. But I don’t know how cost effective it would be to do that,” he said.

Stop loss

Asked about his view on the discretionary call option, he said he was neutral.

“It’s an opportunity cost, but look at it that way: you only get called if things go well for you. It’s because you get this high return that the issuer had to introduce the call. From their perspective, it’s a way to protect themselves. They have to hedge their risk because a 10% coupon is rather high; overall the terms are relatively favorable to the client. From their perspective, it’s a stop loss.”

In conclusion, Kownatzki said he would probably not buy the notes, not because he did not like the product but because he lacked the required level of conviction to buy it.

“I’m sitting on the fence here. I’m not sure 100% one way or the other. There are pros and cons. I probably wouldn’t use it simply because I just don’t know for sure.”

Upside risk

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, also analyzed the notes in a balanced way.

In his view, the best part of the deal is the barrier. One of the worst aspects of it is the discretionary call.

A 30% drop in the S&P 500 would push down the benchmark to its 2013 levels at around 1,640, he noted.

“There is a reasonable amount of protection there,” he said.

“The S&P is richly valued, but I don’t see it falling that low.

“I’m not too concerned about the downside. I’m more concerned about the upside.

“You’ll never see the full 30% at maturity. If the deal works to your benefit, they will call it much sooner.”

In general, Chisholm said he does not show worst-of products to his clients.

“They’re complex. I don’t find them very marketable,” he said.

Volatility and call

Another problem is the volatility play embedded in the notes.

“With this note you’re really opting for a flat to slightly down scenario for the worst of these two indexes. If the market is down 30% or less, you’ll do fine. But again if the market does well, you’ll get called,” he said.

Investors buying the notes would benefit from a decline in volatility. He said such trend is unlikely.

“Volatility is so low right now it can only go up. For the next three years, I can’t imagine that we won’t have more volatility either up or down and in both markets,” he said.

He defined the limits of the structure in those terms: “In order to get the upside, you would need to not get much upside, otherwise you’ll be called.”

Tax reform

Finally, another risk factor is Washington.

“The market is likely to move up or down in response to new policies. A lot will depend on the tax reform. If there is no tax reform, then certainly the S&P could plunge. If there is a tax reform, the S&P and the ETF could surge because the economy as a whole would be stronger,” he said.

But a tax bill would be unlikely to pass before six months from now, he said.

“So you’re investing six months before an expected tax reform that has the potential to increase earnings and push up stock prices in rally mode again. You’d be limiting your upside at the wrong time.”

The notes offer a mixed picture.

“There are benefits and downsides. The benefits are the enormous amount of protection and a 10% return. On the downside, you can get called right away very easily if the market picks up from there. That’s without mentioning the odd timing and the fact that you’re missing out on the dividends even if they’re not substantial,” he said.

“I don’t really have a strong opinion one way or the other except that I wouldn’t show a worst-of to a client because they’re just pretty unattractive.”

The notes will be guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. is the agent.

The notes will price on April 25 and settle on April 28.

The Cusip number is 40054L4P6.

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