Goldman Sachs’ absolute return notes linked to Dow aimed at mildly bearish investors

By Emma Trincal

New York, Jan. 30 – GS Finance Corp.’s absolute return notes due Feb. 10, 2021 linked to the Dow Jones industrial average provide more benefits in a downside scenario than in an uptrending market, making the notes more eligible for bearish investors, especially those with a mildly bearish bias, a financial adviser said.

Another source said the notes represent a reasonable bet on a range-bound market validated by a U.S. equity market trading at all-time highs.

If the index finishes above its initial level, the payout at maturity will be par plus the gain up to a maximum upside settlement amount of $1,350 to $1,410 for each $1,000 principal amount.

If the index falls but does not finish below the 70% knock-out level, the payout will be par plus the absolute value of the index return.

Otherwise, investors will be fully exposed to any losses.

The notes will be guaranteed by Goldman Sachs Group, Inc.

Mildly bullish

Jerrod Dawson, director of investment research at Quest Capital Management, said most of the risk on the notes is on the upside, but he downplayed it.

“Given the Dow recently hitting 20,000, markets are a little bit fully priced,” he said.

“You’re getting about 9% a year. It’s not the full upside, but it’s probably in line with the historical average.”

He also likes the downside.

“You have a pretty meaningful absolute return that gives you some protection should you have some pressure.”

A bullish investor expecting double-digit returns would not be considering the product, he added.

“But given where we are in the market cycle and some of the uncertainty around the new policies of the Trump administration, any return in the 9% to 10% range should be reasonable.”

Trade-off

Investors in the notes give up the full upside for the benefit of the downside protection and absolute return.

“The trade-off is in your favor,” he said.

“All you’re really giving up is a double-digit gain. But how likely is it that the Dow will post double-digit returns in the next four years? If you get 35% in four years, you probably won’t be worse off than someone long the index.”

Dawson did not deny that there is a chance for investors to miss on some of the upside.

“But the risk of giving up double-digit returns is not as high relative to the benefit of the barrier and absolute return.”

Dividends

Steven Foldes, vice-chairman at Evensky & Katz/Foldes Financial Wealth Management, is more skeptical.

The note is “interesting” for its “modest” upside, he said. But he found a series of “problems” with the product, starting with the cap on the upside and the “long” tenor.

He pointed to the “loss of dividends” over a four-year period. The Dow yields 2.25%, and the noteholders must forego dividends. As a result, the deal “cut” their return by 10.4% on a compounded basis over the term, he noted.

“If your cap is 10% a year, a quarter of that you’re losing to dividends,” he said.

“I never like my upside to be capped. But with no leverage and no dividends, you’re underperforming on the upside.”

This would make the product inappropriate for a bullish investor, he said.

Downside

The downside barrier coupled with the absolute return feature is “nice” but probably unnecessary at best and insufficient at worst.

“You have to ask yourself the question, do you really think that four years from now the Dow is going to be negative?”

Historical data points to low probabilities, he said.

As a result, investors are unlikely to need the protection and to benefit from the absolute return, he said.

“From a statistical standpoint, the probabilities of this index being negative in four years are very slim,” he noted.

On the other hand, investors are not sheltered against a serious bear market since the protection offers no guarantee as it is the case with a buffer.

“There is a slim probability to finish negative. But if it does happen, if we have one of those horrific markets like in 2008-9, 30% won’t be enough to protect your principal. The note could be very negatively impacted.”

Mildly bearish

Foldes concluded that the notes offer no incentives to bullish investors, who would be better off getting the full market exposure with the dividends and the full upside.

The main appeal of the structure is on the downside. But the bearish view has to fit within the boundaries of the barrier.

“A person buying this note ... number one, wouldn’t mind having their money tied up for four years, number two, would expect the index to finish negative and number three, would have to believe that the market would not collapse in four years,” he said.

“It’s a mildly bearish view.

“I wouldn’t want to bet that four years from now, the Dow will be down from zero to 30%.”

Goldman Sachs & Co. is the underwriter.

The notes will price on Friday and settle on Feb. 10.

The Cusip number is 40054KUU8.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.