Goldman’s buffered digital notes linked to Russell 2000 to fit range-bound, even bearish view

By Emma Trincal

New York, May 5 – Goldman Sachs Group, Inc.’s 0% buffered digital notes due June 1, 2018 linked to the Russell 2000 index could be used as a hedging tool given the structure’s potential to deliver positive returns in a down market as long as the negative performance is within a range, sources said.

If the index finishes at or above 85% of the initial level, the payout at maturity will be par plus a digital return of 15%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be exposed to any losses beyond the 15% buffer.

Opportunity cost

Tom Balcom, founder of 1650 Wealth Management, said there is the potential for opportunity cost, but the structure does a good job of mitigating downside risk.

“The only way to underperform is if the index ends higher than the 15% digital return. If the Russell finishes up 20%, you’re capped at 15%,” he said.

“But that’s an opportunity cost, not a loss.”

The type of investor for the notes would be conservative.

“If you have a long-only exposure to the Russell 2000 and worry about the market being at peak level, it might be a good solution to hedge a portion of your allocation to small caps against a potential drawback over three years,” he said.

“You risk missing on any return above 15%. But if you’re a more defensive investor, it makes sense.”

The notes would not appeal to everyone, he explained.

“You have to be really worried about the downside risk. You may even expect a correction. The digital return on an annualized, compounded basis is only 4.77%. That’s very low. Historically, returns are over double that. You can’t get into this trade if you’re bullish,” he said.

“You’re either conservative or bearish. If you’re bullish, it doesn’t make sense to go for that type of return.”

Bears may like it

Slightly bearish investors may especially like the notes because they can turn a negative performance in the index into a gain, he added.

“As long as the Russell doesn’t fall beyond 15%, you’ll make 15%,” he said.

“If you’re down 10%, you make 15%.

“This makes the terms on the downside very attractive.

“You have that positive return within a negative range, and on top of that, you have the buffer.

“In a way it’s similar to a twin-win, but it’s actually better than a twin-win.

“The notes give you a better outcome for a down market because twin-wins have barriers and this is a buffer.

“Suppose the market drops 20%. With a twin-win you’d lose 20%. Here you’re only losing 5%.”

Balcom said he could think of several clients who may like the notes’ payout.

“If you worry about a bear market, this can be very useful. If the market is down 15% and you make 15% in return, you would be a hero to your clients.

“But the structure has its limits. The return is not all that high, and you’re capped. You have to be comfortable with that.”

The ideal use of this product would be for hedging, he noted.

“You may use this as a portion of your portfolio because these notes could be a great hedge.

“It’s a hedge definitely. It’s great for that. But as a replacement for a long-only position ... not so great.”

Modest expectations

Don McCoy, financial adviser at Planners Financial Services, said the notes would be appropriate for investors who don’t expect high returns in small caps.

“Sounds like a pretty good product for people who have modest expectations from the market. Small caps, which are overvalued, may have limited upside after being up for six years in this market,” he said.

“It might be a good play for people who want to know their potential return while getting a strong protection on the downside. You know exactly when you’re going to get your 15%. Fifteen percent return is pretty good if you anticipate the market to be flat or slightly negative.”

Fixed return

Some investors like to know what their potential return may be, he said.

“People always want to know what their portfolio is going to do on a year-to-year basis even though you can’t tell them what it’s going to do,” he said.

“We try to educate people that 9.6% is the historical average of stocks, yet it almost never returns 9.6%. It’s going to be above it, below it, way below it.

“You just don’t get a set amount of money.

“I don’t think investors would buy this note thinking, I’m going to get 4.75% a year. If they did that, they could probably find some fixed-income product instead, although I don’t think you would find a fixed-income instrument that would give you 15% in three years.

“I think people buying these notes have low expectations from small caps, but they want the exposure.

“The guaranteed 15% return takes out the question mark about returns. It’s not a high return, but you have a significant downside protection.”

Goldman Sachs & Co. is the underwriter.

The notes will price May 27 and settle May 29.

The Cusip number is 38148T2N8.

Barclays

Separately, Barclays Bank plc plans to price 0% buffered digital notes due Nov. 30, 2017 also linked to the Russell 2000, according to a 424B2 filing with the SEC.

The structure, six months shorter, offers a comparable digital return in the 14.75% to 15.75% range.

However, the threshold to receive the digital payment is higher: at or above the initial price instead of 85% of it.

The notes have the same buffer amount of 15%.

The Barclays notes will price a day prior to Goldman’s offering and settle on May 29.

The Cusip number is 06741UUU6.

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