GS Finance’s 24- to 27-month digital notes linked to Russell 2000 offer defensive play

By Emma Trincal

New York, June 28 – GS Finance Corp.’s 24- to 27-month 0% digital notes linked to the Russell 2000 index are designed for cautious investors who want protection or even gains in a downside scenario, sources said.

The notes will be guaranteed by Goldman Sachs Group, Inc., according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is greater than or equal to negative 15%, the payout at maturity will be equal to a fixed digital payment, which is expected to be 12.9% to 15.1% and will be set at pricing. Otherwise, investors will lose 1.1765% for every 1% that the index declines beyond 15%.

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said the notes may be a good fit for a specific type of investor. But he would not consider buying them based on his economic outlook.

Good alternative

“If you expect the Russell to trade sideways for the next couple of years, this would be a better choice than buying the Russell outright,” he said.

“Getting 15% in the next two years would be a reasonable return if your expectations are modest.”

In addition, an index price decline of 15% or less would generate the same return, which is an attractive aspect of the structure, he noted.

But Chisholm is cautious about the risks of a pullback.

“From our perspective we don’t see a lot of upside in the U.S. In fact, we think it’s possible for the Russell to lose more than 15%,” he said.

Economic headwinds

“The U.S. economy will probably be in a recession in the next few years if it’s not already. I don’t see equity investing as the best place for funds. We’re very defensive right now. The Russell 2000 is not high on the list of investments we would make in the next two years. We see better opportunities.”

Those alternatives derived from Chisholm’s outlook on the U.S. economy.

“We feel that deflationary forces are quite strong regardless of central banks’ talk. Deflation is a very serious issue. We have negative interest rates in several countries in Europe, in Japan. We’re seeing it here too with some banks. Large institutions, pension funds, reinsurance companies are investing in physical cash and gold, a telling sign that there are greater issues at play.”

As a result, Chisholm said he invests his clients’ assets in U.S. Treasuries, some high-grade corporate bonds and precious metals.

Risk parameters

Jonathan Tiemann, president of Tiemann Investment Advisors, said the notes are “defensive” in nature as investors are “selling the upside” for more downside protection.

“It’s kind of a 7% yield. It’s a certain return unless the market is substantially dropping,” he said.

The payout on the downside contains what he called a “cliff,” however. Investors may go from a positive return of 14% (assuming it is the final digital payout) to losses if the index drops more than 15% by just a small amount.

“It has some appeal in the sense that it offers this sort of 7% coupon. It’s an interesting way to slice and dice the risk in a way that you’re going to get that 7% in most outcomes. There’s a pretty high probability of getting it.”

At the same time, the return is limited.

“You’re selling the upside. In order to get this fixed return in a broad range of outcomes you’re foregoing the dividends and you’re capped. The instrument is lower volatility than the underlying market, but you’re giving up what could be a substantial amount of upside.”

Tiemann said he does not have a specific view on the benchmark.

“But you would be sorry if the index rallies 30%,” he said.

It’s not income

For the right investor with no great expectation on the index performance, the notes could deliver better returns than the benchmark. One concern though is how investors would perceive and therefore plan on using the product.

“What worries me about it is that it might be tempting for somebody to try and reach for yield. If the market takes a header, you could get burned,” he said.

“It’s a conservative play compared to an equity position, but you’re taking a fair amount of risk for 7% a year.”

Goldman Sachs & Co. is the underwriter.

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