Goldman Sachs’ digital notes linked to Euro Stoxx 50 index offer defensive play on euro zone

By Emma Trincal

New York, July 17 – Goldman Sachs Group, Inc.’s 0% digital notes linked to the Euro Stoxx 50 index offer a modest payout but one that can be captured even in a slightly down market, making the product attractive to conservative investors, said Suzi Hampson, structured products analyst at Future Value Consultants.

The notes will mature between 18 and 21 months after pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes at or above the 85% barrier level, the payout at maturity will be the maximum settlement amount of $1,065 to $1,076 per $1,000 principal amount of notes.

Otherwise, investors will lose 1.1765% for each 1% decline beyond 15%.

“We have a challenge in scoring this product due to the unsettled terms. The issuer gives us a range in digital payouts and a range in maturity. In order to produce a report, we have to pick fixed values,” Hampson said.

“We gave them the benefit of the doubt by choosing 18-month, the shortest end of the maturity range, and a digital payout of 7.32%, which is 25% below the upper end.

“Obviously our scores could change for the worse if the duration ended up being 21-month instead of 18 and the return 6.50%. We have to make assumptions, but what we chose leans toward the best possible outcome.”

Defensive

Future Value Consultants in its research assesses risk, return and price using a variety of proprietary scores in order to compare a product to others in the same product type. For this note, the structure type is digital.

“It’s not your usual type of digital note as you can get your 7.32% payout even if the Euro Stoxx is down as long as it’s not down by more than 15%,” she said.

“Typically the digital is triggered above the initial price, not above a negative threshold. This gives the notes a defensive edge. By nature it’s not a particularly aggressive product. You’re not going to outperform the market if the index grows at an average or high pace.”

The digital payout in effect “caps” the upside at less than 5% per annum.

“Naturally this relatively low cap is there because you can capture the return even if the index is down to a point, in which case you would outperform. This product is designed for a flat or even slightly bearish market,” she said.

On the downside, investors benefit from a 15% buffer.

“It’s slightly geared down, so if the index price collapses in theory you could be down to zero and get nothing back,” she said.

“But it seems to be a reasonable amount of protection compared to similar products around. It’s not a particularly risky offering.”

Protection

The 15% buffer combined with the fact that the payout threshold is below the initial level – unlike most digital products – makes the notes attractive for conservative investors who want exposure to the European equity market, she said.

She noted that the buffer and digital thresholds are at the same level.

“If the index is hovering around minus 15% at maturity, you’re getting into a very sensitive zone. You could get the return or lose principal if the price moves up or down by a few basis points,” she said.

While the 7.32% return over 18 months does not seem “very exciting,” it may appeal to more cautious or slightly bearish investors.

“This lower return reflects the fact that you’re more likely to get paid when the index can go down 15% than if it had to stay flat or go up. If the threshold was 100 instead of 85, you would have a higher return but the probabilities of getting the return would be reduced.”

Investors in the notes express a choice.

“Do you want the higher return with more chances of not getting it? Or do you prefer what the note has to offer – a slightly lower return but greater odds of getting it? It’s not high, but it’s the cost of having a level below 100.”

Market risk

Future Value Consultants calculates the market risk and the credit risk and adds the two components to generate the “riskmap,” which measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible.

The product has a 1.53 market riskmap versus an average score of 2.84 for its peers, according to Future Value Consultants’ research report.

“It’s nearly half of the average for this product type. This note has a slightly better buffer, which contributes to the lower riskmap. Other similar products may have barriers, smaller buffers or nothing at all,” she said.

“This low risk level is consistent with the very modest return. It suggests that investors are aiming for a lower-risk kind of product, not an aggressive one.”

Credit exposure

The notes have a 0.52 credit riskmap versus 0.44 on average for the product type, the report showed.

Sometimes the credit risk is lower due to longer maturities, which is not the case with these notes, she explained.

“I expect this result to be due to the creditworthiness of the issuer,” she said.

Goldman Sachs has five-year credit default swap spreads of 86 basis points, according to Markit. That level as of Friday was wider than other U.S. banks. Morgan Stanley and Citigroup for instance have spread levels of 78 bps each; Bank of America, 69 bps and JPMorgan, 68 bps, according to Markit.

Return score

Future Value Consultants measures the risk-adjusted return of each product with its return score.

The score is calculated using the best assumption among five key market scenarios.

At 6.68, the return score is lower than the 7.16 average for the digital product category, according to the report.

“This score is pretty sensitive to the ranges, and we already picked some of the best terms regarding return and duration. It could be even worse. This risk-adjusted return score suggests that while the risk is quite low and while you may not easily find other digital products with similar low levels of risk, the issuer is not offering enough return,” she said.

Good value

For each product, Future Value computes a price score that measures the value to the investor on a scale of zero to 10. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score is 7.37 versus an average of 6.18 for similar products, the report showed.

Return scores and price scores often tend to move in the same direction, but with this note, they differ quite a bit, she said.

The difference can be due to the fact that Future Value Consultants rates the price based on the market neutral assumption (cash returns) while return scores are determined based on an optimal scenario picked from five different market environments, she explained.

“We look at five assumptions and pick the best one for the return score. This product would do best in a bullish scenario, and the return is scored accordingly,” she said.

The use of a bullish assumption may explain why the product lags its peers so much on the return scale.

“This is not the common digital product,” she said.

“Its defensive profile is not quite suited to our bullish scenario. Perhaps an investor looking for a defensive product should compare it with other digitals that meet the same profile. There are probably not many. I don’t think the return score is too off putting in this case just because of that.

“Meanwhile the price score is encouraging. It suggests that the issuer spent enough on the options and that the product has good value.”

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The product shows a 7.03 overall score versus 6.67 for the average of its peers.

“The overall score is good. We average out price and return scores. The higher price score more than offsets the low return score. That gives us an overall good rating,” she said.

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