GS Finance’s index-linked notes on S&P 500 offer full principal protection over short term

By Emma Trincal

New York, July 6 – GS Finance Corp.’s 0% index-linked notes expected to mature on July 24, 2025 tied to the S&P 500 index offer 100% downside protection in a relatively short tenor, a contrast with similar deals, which only recently required much longer maturities, sources said.

If the final index level is positive, the payout at maturity will be par plus the index gain, subject to a maximum return of par plus 25.01%, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, the payout will be par.

No market risk

“That makes sense. The upside is limited. There is no leverage, not digital and it’s capped. But you can’t compare this to a buffered note. It’s 100% principal-protected,” a market participant said.

“It’s like a market-linked CD except for the FDIC protection, which you don’t have in a note. Potentially, you can make 8% a year and there’s no downside.”

Principal-protected notes are a good fit for risk-averse investors, a financial adviser said.

“No risk. That’s the key. You can show this to a client who doesn’t want any risk. Mr. or Mrs. Client, here is a note where you can’t lose money,” this adviser said.

“It helps with inflation. You can’t earn 8% anywhere today with most bonds, let alone cash.

“Of course, this note doesn’t pay any coupon. Your 8% a year is not guaranteed. But if the market is up, you may very well get it over three years.

“In fact, what’s attractive here is the three-year term. It was nearly impossible before to get any principal protected note on the S&P for less than six years, sometimes longer.”

Interest rate risk mitigation

Principal-protected notes can be used as fixed income replacement in a portfolio, he said.

“It’s similar to a bond. You can’t escape some level of interest rate risk. But the structure of the product reduces some of it,” he said.

A market participant clarified the point.

“Interest rates will affect the value of your note in the same direction as if you owned a traditional bond. If rates go up, the price of your security goes down,” he said.

“But the options, which are not fixed coupons, will counteract some of that interest rate risk.”

This would be the case with equity underliers, he noted.

“Now if the notes are tied to the interest rate itself, like a floater, you’re taking a lot of interest rate risk. It’s going to behave very much like a normal bond.”

Rates, volatility

Changing pricing conditions have enabled issuers to show principal-protected notes with much better terms than before.

“It’s been so long since we’ve seen those principal-protected notes. Interest rates were too low. First you had very bad terms and very long maturities. Then issuers were no longer able to price anything at all, he added.

The economics weren’t there. Now that rates are higher, those products are slowly coming back.”

Higher rates and lower volatility are the main factors behind good pricing when it comes to principal-protection, he said.

“Higher rates are key. They give you more money to purchase the options,” the market participant said.

Principal protected notes combine a zero-coupon bond and an option. The zero delivers the principal protection while the option provides the return based on the performance of the underlying. When rates increase, the price of the bond declines. As a result, the zero-coupon bond will trade at a deeper discount, allowing the issuer to tap into more capital to purchase the options.

The other factor is the volatility.

“Investors are buying call options through the structure. So, you want volatility to be lower because it reduces the cost of your options,” he said.

“You are selling a call to produce your cap. But net/net, you’re still buying options.

“It’s very different from a buffered note where investors are selling options.”

Phantom income

One negative aspect of these products is their tax treatment.

Investors have to pay taxes on ordinary income from the notes over the entire term even though they do not receive any income. This type of income is known as “phantom income.”

Gains at maturity are also taxed as ordinary income.

“It’s the downside of these products. You have to pay the phantom income tax. But that’s the kind of sacrifice people are willing to make in order to get the full principal-protection,” the market participant said.

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the underwriter. JPMorgan is the placement agent.

The notes are expected to price on July 21 and settle on July 26.

The Cusip number is 40057ML56.

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