GS Finance’s digital notes linked to Russell 2000 index can be used as hedge, mitigate risk

By Emma Trincal

New York, Jan. 15 – GS Finance Corp.’s 0% digital index-linked notes due Jan. 31, 2019 linked to the Russell 2000 index can generate a positive return when the market declines, at least up to a point, which makes the product a possible hedging tool for a long portfolio, said Tim Vile, structured products analyst at Future Value Consultants.

If the index finishes at or above the 85% trigger level, the payout at maturity will be the maximum settlement amount of $1,160 per $1,000 principal amount, according to a 424B2 filed with the Securities and Exchange Commission.

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

“These notes belong to our digital category,” said Vile.

“You get a certain fixed payment when the underlying closes above a set level. Usually that level is the initial price but not always. In this case it’s at a lower threshold.

“There is a mildly bearish element in this structure because you can make money even if the index is down.

“However, the index can’t fall by more than 15%, otherwise you don’t get that return. If it does, you lose some principal too, but the buffer will significantly mitigate your risk.

“If the index is down 16%, you only lose 1%. Most of those products have a barrier, not a buffer.

“These two features – the digital gain if the index falls by less than 15% and the buffer – contribute to make this note attractive for conservative or slightly bearish investors.”

Hedge

The 16% digital payment over three years represents only 5.07% a year with compounding.

“That’s not much, but you can get this return even in a correction, assuming the correction does not exceed 15%,” he said.

A correction is a market downturn of at least 10%. In a correction showing a 10% to 15% decline, investors would receive a positive return. However, a bear market, defined as a market loss of at least 20%, would hurt investors as they would lose the amount of market decline minus the buffer amount.

“Obviously if your threshold to get the digital was higher, at the initial price as it’s usually done, your upside would be higher too,” he said.

“This is a note for moderately bearish investors. For mildly bullish investors, the product still makes sense.

“It can be used as a hedge or some form of return enhancement for investors with a long position in the Russell 2000.”

Non-directional

Vile compared the product with another type of structures known as absolute return or dual directional notes.

“There are similarities. You make money in a down market too” he said.

“The difference is that you don’t get any participation in the downside. It’s a digital. You either get it or you don’t.

“This type of payout makes your return jump proportionally higher. That’s another way to look at the low cap. A pure absolute return note would probably come with a higher cap. But this one offers some form of leverage on the upside and a buffer on the downside. Investors have to pay for those benefits.”

Muted risk

The firm calculates the market risk and the credit risk of a product. Adding them up, it generates 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 market riskmap for the notes is 1.94 versus an average score of 4.13 for digital products, according to Future Value Consultants’ research report.

“It’s very low. That’s essentially the buffer. A 15% buffer on a three-year is quite strong,” he said.

“The Russell 2000 is slightly more volatile than the S&P but not by a lot, so it doesn’t alter the risk level.”

The credit riskmap, 0.70, is higher than the 0.58 average score for digital products.

“Goldman Sachs has slightly higher spreads than its peers. That’s why the credit risk is greater,” he said.

Goldman Sachs’ credit default swap spreads were at 103 basis points on Friday, according to Markit.

Morgan Stanley was at about the same level with spreads at 102 bps. But JPMorgan and Bank of America showed levels of 85 bps and 87 bps, respectively, while Citigroup’s spreads were below 100 bps at 98 bps.

Most banks have seen their spreads widen since the beginning of the year by about 15 bps.

Adding both risk components results in a riskmap of 2.64 versus an average of 4.70 for similar products and 4.30 for all products, the report showed.

“This is really the positive part of this trade. The risk is at the lower end of the spectrum,” he said.

Risk-adjusted return

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets, and high and low volatility environments. The appropriate market assumption for this product would be bullish.

The return score is 7.09 versus an average of 7.56 for similar products and 7.02 for all products, according to the report.

“It’s not bad. It’s slightly less than the average for the product type but not by a lot. It’s comparable to the average of all products,” he said.

“The low risk really helps. Without a low riskmap, this product would have struggled to keep a good return score.

“Given how low the risk is, it appears that the digital really caps off the return.”

Value

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

The notes have an 8.06 price score versus an average of 6.20 for the product type, according to the report.

“It’s very good,” he said.

“The three-year term helps pricing because you have more years to amortize the cost.

“The issuer spent a good amount on the options. There is a 15% buffer, a 16% digital, which is not massive but you can get it in a down market. It’s linked to the Russell and not some random stock.

“Investors get some decent value.”

Overall score

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

The notes have a 7.58 overall score while the average for the product type is 6.88 and the average for all products is 6.82.

“It’s a good score overall,” he said.

“For someone looking for a target return, the note could be a good option.

“There is less risk than average given the buffer.

“The 5% return is not huge, but it allows you to hedge the downside.

“You can actually outperform the Russell by up to 31% if the index drops 15%. You can think about it that way. You can hedge the market. You can outperform the market.”

Goldman Sachs & Co. is the underwriter.

The notes will price on Jan. 27 and settle on Jan. 29.

The Cusip number is 40054CAL8.

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