GS Finance’s index-linked notes offer uncapped leverage, buffer on fairly short term

By Emma Trincal

New York, Aug. 2 – GS Finance Corp.’s 0% index-linked notes due Sept. 6, 2024 linked to the least performing of the Dow Jones industrial average, the Russell 2000 index and the S&P 500 index give investors 1.3 times the positive return of the worst-performing underlying with no cap while providing a 10% buffer on the downside, terms which advisers tend to favor especially on a three-year tenor.

No cap

“For a three-year, these are the terms you would expect on a five-year note,” a financial adviser said.

“To get not only 1.3x, but uncapped, on a three-year...I was pleasantly surprised.

“This is typically the kind of notes we like to work with.”

This adviser said he strives to offer his clients notes with no maximum return.

“It has served us well. If you had bought a capped note six years ago, would you be happy with a cap?

We always try to get uncapped notes. It has served us well. If you had bought a capped note six years ago, you wouldn’t be too happy today.

“If I can get leveraged great. But what I really want the most is uncapped returns. Being able to get both is great.”

Three-year losses

This adviser said he had a hard time finding some flaws with the structure but tried anyway.

“It’s a worst-of. You have to take that into consideration. At the same time, it’s with worst-of notes that you can get the best terms. It is what it is. At least it’s on three broadly diversified indices, not on three sector ETFs,” he said.

If one aspect of the deal may raise concerns it would be the tenor.

“In my opinion, three-year is the highest risk period,” he said.

“With a one-year, well anything can happen. On a five-year you’re probably going to have at least one or two down years but also three up years.

“But the three years...that’s when you may run into trouble.”

To back up his view, he used historical performance data on each index. His longest track record is 70 years on the S&P 500 index. The data he has collected on the Dow Jones industrial average and the Russell 2000 index is for the past 35 years.

Looking at the S&P 500 index only, he found that it’s on a 34-month investment that there is the greatest probability of losing 20% or more. A 27-month period showed the greatest likelihood to produce losses in excess of 30%.

“So statistically, it’s when you invest for three years that you’re the most likely to get the big losses,” he said.

“As a result: you’d better have either a big barrier, like a 40% barrier, or a buffer.

“This one offers a 10% buffer. I really like that.”

“When you have a severe bear market, your go through the barrier. The buffer guarantees a certain amount of protection.”

What’s not to like

This adviser continued to analyze different aspects of the deal, trying to come up with objections. But he said the exercise was the equivalent of “splitting hair.”

“I’m really hard-pressed to find anything wrong on that deal,” he said.

Goldman’s credit default swap rates are wider than other issuers.

“But it’s still Goldman. It’s not going anywhere. And it’s a three-year. The shorter the note, the less emphasis on credit risk,” he said.

The non-disclosure of the fee in the prospectus was just an inconvenience.

“That would be one thing I would want to know, of course,” he said.

“However, at the end of the day, what I care about are the terms. Normally when the fee is high your terms suffer.

“I’ve got to believe that the fee is low on that one.”

True exposure

One possible disadvantage with worst-of is how they may fit in a portfolio.

“This note could behave like a large-cap or small-cap. We don’t know because your exposure is unknown until maturity,” he said.

“In theory, it may complicate your asset allocation a bit.

“But no one should be too caught up in the diversification arguments. Your goal is to make money for your clients no to fill out correctly your Morningstar grid,” he said.

The three-year timeframe seemed to be the most tangible shortcoming.

“I would just warn my clients that three years is usually the period with the highest percentage of losses. But when you’re already in the market, you’re already taking that risk,” he said.

Dividends

Giving up the dividends is not a negative aspect of the product. It’s the common fate for all investors in structured notes, he said.

But the “sacrifice” has become less painful with current dividend yields, he added.

“You give up dividends. Nothing new here. But equity yields have come down a lot. The S&P 500 index yields only 1.34%. The dividend yield of the Dow Jones is 1.78% and the Russell 2000 index pays a dividend of less than 1%.

“On a three-year basis you’re giving up 4% or 5% for a 10% buffer. That’s a pretty good tradeoff,” he said.

“This note is better than most of the notes we’ve been doing for the past three years.”

Buffer

Carl Kunhardt, wealth adviser at Quest Capital Management, favored the buffer but disliked the worst-of.

“The alternative is being long, and if you’re long you’ve got 100% downside exposure, so you’re better off with the buffer,” he said.

“The only thing I don’t like is the fact that it’s a worst-of three indices.

“Anytime you go worst-of plus leverage plus downside protection, you’ve already created a complex strategy.”

Explaining the exposure

Investors however are already familiar with buffers and leverage.

“The real level of complexity here is the worst-of,” he said.

While Kunhardt manages his clients’ accounts on a discretionary basis, the worst-of would warrant a conversation or explanation.

“I wouldn’t put a client in something like that without sitting down and explaining it. Just because I can doesn’t mean I should,” he said.

“So, the only negative here is the worst-of. But in this day and age, you can’t get away from worst-of.”

Overall, Kunhardt agreed that the notes offered more benefits than shortcomings.

“It’s a good enough note.

“Three-year, no cap, a 10% buffer, 1.3 times leverage. It’s only 1.3 times but anytime you get better than 1 it’s gravy.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The upside participation rate will be at least 130%, with the exact rate to be set at pricing.

The notes are expected to price on Aug. 31 and to settle on Sept. 3.

The Cusip number is 40057J4C7.

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