Goldman’s buffered digital notes linked to Dow Jones industrial average lack ‘exciting’ return

By Emma Trincal

New York, May 15 – GS Finance Corp. plans to price 0% 18-month buffered digital notes linked to the Dow Jones industrial average, according to a 424B2 filing with the Securities and Exchange Commission.

If the final index level is greater than or equal to the initial index level, the payout at maturity will be par plus 9.5%. Investors will receive par if the index declines by 12% or less and will lose 1% for each 1% decline beyond the 12% buffer.

Carl Kunhardt, wealth adviser at Quest Capital Management, said the upside potential of the notes is not “exciting.” Nevertheless, the payoff could be adapted to a moderately bullish market.

Benchmark

“I’m agnostic on it,” he said.

The Dow would not have been his first choice as the underlying.

“The Dow is only 30 stocks. It’s a very narrow set of the stocks that represent the U.S. equity market,” he said.

“At the same time, you have to realize that most people consider it as the bellwether for the market. These are the blue chips. You can’t ignore it.”

Slow growth

The main question is one’s view about the future performance of U.S. stocks.

“Do I expect the Dow to be less than 6% a year? The answer to that is maybe,” he said.

“We’re eight years into the bull market. At what point does reality come into play?

“I’ve been singing that song for two years, and I’ve been wrong so far.

“But at some point these valuations have to come down to more appropriate levels.

“Six percent may be all we can expect from the S&P over the next 18 months.”

On a compounded basis, the digital payout of the notes provides a 6.3% annual return.

Kunhardt pointed to the main benefit of a digital coupon.

“I’m not very excited about the upside potential, but we are in a low return environment, and if the Dow doesn’t go anywhere, if it’s up just a little bit, it gets me the 6%,” he said.

Buffer

The 12% buffer on the downside could be used as a hedge in a core equity portfolio.

“I don’t have that buffer when I’m holding an ETF, a mutual fund or the stocks outright. Since I’m going to have exposure to these 30 stocks anyway, I can see using that for a small position for the protection.”

The notes would be the most appropriate for conservative clients.

“I would consider the note. I wouldn’t say it’s my favorite note, but I could see it having a place in a portfolio, especially in a defensive portfolio.”

Credit

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that while the notes offer some advantages he would not show them to his clients because of the unappealing risk-adjusted return.

On the credit risk scale, Kalscheur said an 18-month term represents manageable risk.

Goldman Sachs has credit default spreads wider than its peers. But spreads have tightened a lot all across the board, a testimony of the strengthening of the banks’ balance sheets in the United States over the past decade, he said.

The simplicity of the product is also a plus.

“Everyone knows the Dow. It’s easy to understand. The structure is very straightforward,” he said.

“It’s hard to tell what’s going to happen in 18 months, but a 12% buffer is going to give you a decent amount of protection over that period.”

Backtesting

Investors in the notes may outperform two-fold: first, on the upside if the index finishes positive by less than the digital amount of 9.5% over the 18-month term and, second, if the Dow declines by less than the buffer value of 12%.

Kalscheur uses backtesting when assessing a structured note.

Reviewing the past performance of the Dow over 18-month trailing periods since 1950, he found that the probabilities of losses versus gains do not favor investors in the notes.

On the upside, the chances of outperforming – an index gain below 9.5% – are only 18%.

On the downside, the probability of a decline contained within the buffer zone is 12%.

Outcomes

“That’s only 30% of the time that you’ll get to be inside that band where you can beat the benchmark,” he said.

The downside risk – seen when losses exceed the buffer – is relatively contained with an 11% probability.

The “upside risk” is much greater. Over the 18-month term, the index would generate gains over the 9.5% cap 59% of the time.

“You’ll be capped out 60% of the time. You leave a lot of money off the table,” he said.

“It’s really hard for me to get motivated or convince a client to take equity market risk with such limited upside.

“Just because there is a 12% buffer doesn’t mean there is no equity risk. You’re buying the equity markets regardless of where you think the stocks are going to be.

“To take that type of risk for just 6.3% a year is not exciting at all.”

Alternatives

Kalscheur said he could show his clients “half a dozen” bond investments offering a 6% return over the next year, citing for example international bonds, high-yield bonds, preferred stocks and real estate investment trusts.

In addition, investors in the notes would have to give up about 3% of dividends based on the 2.2% dividend yield of the Dow.

The backtesting as well as the non-payment of dividends make it too unlikely for investors to outperform the market with the notes, he said.

“I’m not thrilled about the value added here,” he said.

“If you’re going to go in stocks, you have to be rewarded. I don’t see anything that can justify investing in this.”

Goldman Sachs & Co. is the agent.

The notes are guaranteed by Goldman Sachs Group, Inc.

The exact maturity date will be set at pricing.

The Cusip number is 40054LCP7.

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