Goldman Sachs' digital notes linked to S&P 500 index aimed at moderately bullish investors

By Emma Trincal

New York, April 23 - Goldman Sachs Group, Inc.'s 0% digital notes linked to the S&P 500 index are designed for investors who anticipate a sideways market for the next two years, sources said.

The tenor of the notes is expected to be 24 to 27 months, according to a 424B2 filing with the Securities and Exchange Commission.

Moderate bulls

If the index return is greater than zero, the payout at maturity will be par plus the greater of 10% and the index return, subject to a cap of 17.9% to 20% that will be set at pricing. Investors will receive par if the index declines by 10% or less and will lose 1.1111% for every 1% that it declines beyond 10%.

"This note is attractive for someone who has a mildly bullish outlook. If you are a raging bull, you wouldn't want to be capped out at 10% per year," said Dean Zayed, chief executive officer of Brookstone Capital Management.

"However, if you expect single-digit returns over the next two years, it's a pretty good deal. It gives you a 5% minimum annual return with a decent buffer.

"It's not for everyone though. It's tailored for people with a specific perspective on the next two years.

"If you think the market will move along somewhat sideways, a little bit up and a little bit down, the note may be right in line with your expectation. You may get a higher return along with a decent buffer.

"But it's only for someone with a very specific perspective, not somebody who anticipates a broad range of different potential outcomes."

Decent buffer

John Farrall, senior vice president, director of derivatives strategy at PNC Wealth Management, said that from a pricing standpoint, the notes offered value because buffers have become increasingly difficult to price.

"For any buffered notes, it's very difficult to do anything in less than three years," he said.

"On the downside, a 10% buffer for that maturity is probably the largest buffer you can afford on the S&P. It's very difficult to price any buffer on shorter-dated products right now.

"I could see why someone who doesn't want to go out three to five years would be interested in that. It's a reasonable return on the upside. If you get an 18% cap, it's still a 9% annualized return."

One of the ways to price the 10% buffer, in addition to the cap, was to introduce the downside leverage rate of 1.11%, applied to each point of index decline beyond 10%, sources said.

But the buffer rate was small enough to make a limited difference when compared to a regular buffer, Farrall explained.

"You have a geared buffer, but with a 10% geared buffer versus a 10% hard buffer, the gearing isn't that much of an issue. The breakeven point where you wouldn't be happy to have the geared buffer is still very down; it would take a strong index decline to get there," he said.

Investors were offered some hypothetical examples in the prospectus.

A 10% decline in the index would not cause any losses with both types of buffers. If the index decline was 25%, investors would lose 15% with a standard 10% buffer and 16.66% with the notes. It's only when the index falls much more that the disadvantage of the geared buffer may become more notable, he explained.

A 75% index decline, for instance, would cause principal losses of 65% with the normal buffer. With the geared one, investors would lose 72.21% of their investment.

Farrall said that the potential return was attractive for investors anticipating only a moderate market upside.

"The digital - if it's up at all you get 10% - is a nice feature in case you have a very flat market. If the market is up even a little bit, at least you win something," he said.

"You're forgoing the dividends compared to someone who would be holding the index fund. But you're getting the 10% digital, and it's definitely better.

"This is for an investor who has a sideway view of the market. If you think the S&P is going to be up 40%, this isn't the note for you. The maximum multi-year return is still pretty low. This will only work for someone who expects the market to trade flat or moderately higher."

Goldman Sachs & Co. is the underwriter.

The Cusip number is 38147K885.

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