Goldman Sachs Bank's CDs on Momentum Builder may appeal to traditional buyers, not all of them

By Emma Trincal

New York, May 16 - For conservative investors used to traditional CDs, the use of a structured CD tied to a complex, proprietary index does not necessarily come to mind. Sources debated the pros and cons of a CD offering proposing a variable coupon with a floor based on an index designed to give investors exposure to a momentum strategy.

Goldman Sachs Bank USA plans to price certificates of deposit due May 27, 2021 linked to the GS Momentum Builder Multi-Asset 5 ER index, according to a term sheet.

The index measures the extent to which the performance of up to 15 underlying assets included in the index outperform the sum of Libor plus a daily index fee of 50 basis points. The index rebalances monthly, and sometimes daily, from among 14 ETFs and one money market position that track equities, fixed-income, emerging markets, alternatives, commodities, inflation and cash equivalent asset classes.

The CDs will pay an annual coupon determined according to the performance of the index measured from the trade date to each coupon determination date, expected to be May 24 of each year, divided by the number of coupon payment dates to and including the relevant coupon payment date. There is a minimum coupon rate of 1% per year.

The payout at maturity will be par.

Momentum with vol. overlay

"The index is rebalanced on a monthly basis based on which asset class provided the highest historical return in the previous six months, three months and one month. This is used to define the 'realized volatility' which may not exceed 5%," said Tony Romero, co-founder and managing partner at Suncoast Capital Group.

"Assuming you have equities and cash and the volatility of equity is 10%. You would allocate 50% to equity to achieve your 5% volatility target," a market participant said.

Romero said he was skeptical about the investment.

"Let us begin with the index. Usually floating rate CDs are tied to some index which is universal and easily determined. This index is proprietary in nature and is in fact a creation of the underwriter, Goldman Sachs."

Liquidity

He stressed the potential lack of liquidity as a significant drawback.

"Call me naïve but I must ask myself what the point to all of this is. If one wanted exposure to certain asset classes, one can simply own the ETFs outright as well as buy the fixed rate CD and keep their lives simple. This would surely provide more liquidity since ETFS can be traded in a very narrow bid/ask spread as opposed to a very thinly traded market as would be the case in a security like this," he said.

Assumptions

The hypothetical returns provided in the term sheet were not encouraging, Romero said, comparing the assumptions with a seven-year Goldman Sachs CD currently offered with a 2.65% fixed interest rate.

"They show in the 'Transaction Summary' four scenarios given with different index assumptions. In none of the examples does the coupon rate exceed 2%, a full 65 basis points less than the plain vanilla fixed rate, easy to understand CD," he said.

"This begs the question: Why? I would have to believe that the secondary market on a security like this will be nearly nonexistent and the only bids offered will come from the underwriter since it is based on an index that not only is extraordinarily complex but that they themselves have created from cloth."

Coupon calculation

Looking at the coupon payment, he admitted that the minimum coupon rate was appealing.

"On the plus side it does have a floor of 1% along with FDIC insurance as opposed to a floor of 0% which is not uncommon," he said.

However, he objected to the payment structure.

"One aspect of this security that is noteworthy is that the closing value of the index is divided by the number of coupons which have elapsed to date," he said.

"For example, suppose the closing value of the index in year seven is 14% you would then take that amount and divide it by seven - the last coupon date - to arrive at the very ordinary coupon return that year of 2.00%."

But the market participant said that the main purpose of the variable coupon was to offer a potentially higher return and that the examples in the term sheet were offered for illustration purposes only.

One advantage of the return tied to the performance of an index was the initial level used as the reference level, he said.

"It's good that they compare the return to the original date. If the index delivers as promised, you get an increase of the value over time with a greater chance of getting a higher coupon. It's better than looking at performance on a yearly basis," this market participant said.

Expected returns

Romero said that the index was too complex to allow investors to make a call on its future performance.

"The index itself is quite diverse and contains ETFs from domestic and foreign equities, government and corporate debt of varying quality, real estate and MLP ETFs as well as money market. It would be pure speculation to attempt to develop a cohesive argument as to the expected collective return of this basket of securities, especially since it is unknown how much of the index will be comprised of each ETF as well as the fact that this composition can change on a monthly basis," he said.

But for the market participant, the expected performance was based on a solidly established strategy. The index methodology itself was transparent to the extent that the rules were consistent and defined.

"The index is built around the concept of momentum. Academic research has shown that momentum is one of the factors that have proven to deliver performance over time. It doesn't mean it works in the future. But it has been a consistent factor of returns," he said.

The index was only created in December. Using back-testing, the term sheet shows an annualized performance of 6.08% since December 2007, he noted.

"If you believe that over the next seven years, this index will have a similar type of performance or even that it will give you more than 2.50% a year, you're better off choosing this structured CD. If you don't think the index can deliver that type of return, then your best bet is to go with the plain-vanilla CD at 2.65%," he said.

"What this structured CD does is give you the potential to get a higher coupon but it's not a guaranteed coupon.

"The choice depends on your risk tolerance and on your expectations from a strategy that combines momentum investing, a style that has proven to deliver consistent returns and volatility overlay."

Complexity

Even if a strategy offers attractive performance potential, it needs to be explained to clients. Romero said that doing that would be a challenge given the complexity of the underlying index.

"This is my profession. I have been trading CDs for 25 years and if it was difficult for me to understand the security I can only wonder how this would be explained to a buyer," he said.

The market participant said that clients could understand the investment however.

"You might have to explain the product and its underlying index a bit more but you have to simplify. If you go into details, you will lose the client immediately. You will have to use accurate and simple explanations," he said.

For Romero, the main purpose of the CD was to deliver cheaper funding to the bank.

"Usually the underwriter and the issuing bank are unrelated. In this case Goldman Sachs the broker/dealer is underwriting CDs for Goldman Sachs Bank. There are no dummies at Goldman Sachs so the bank naturally would like to have the lowest cost of funds possible and there is nothing wrong with that," he said.

"One must understand that a bunch of smart people did not get into a room and put their heads together to think of a way they can pay a higher rate of interest on their deposits and investors must be cognizant of that fact as well."

High-yield solution

The market participant said that the CDs could be a solution for conservative investors seeking FDIC-insured instruments without the penalty of a low yield.

"Why would you do this instead of a traditional CD? A 1% floor is lower than the 2.50% plain-vanilla rate but you can get more than 2.50% and that's what you're buying. You buy some potential upside," he said.

"What are your alternatives? A government bond will pay only 1.8%. A high-yield bond comes with the potential of losing money. A callable note or CD exposes you to reinvestment risk.

"The reality is: your options are limited.

"Some people will want a 2.50% fixed-rate. Others will prefer to lock in a lower rate with the potential to make much more."

The CDs (Cusip: 38147JZP0) will price on May 27 and settle on May 30.

Goldman Sachs & Co. is the agent. Incapital LLC is the distributor.

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