GS Finance’s notes linked to Dow Jones offer full protection, but long tenor, cap are hurdles

By Emma Trincal

New York, March 20 – GS Finance Corp.’s 0% notes due April 1, 2025 linked to the Dow Jones industrial average offer full downside protection, but the tenor is longer than average and the upside is capped and unleveraged, sources noted.

If the index return is zero or negative, the payout will be par, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is positive, the payout at maturity will be par plus the index return, subject to a maximum payout of 185% to 200% of par. The exact cap will be set at pricing.

Too long

The eight-year maturity is a “deal-breaker” for Carl Kunhardt, wealth adviser at Quest Capital Management, even though he otherwise likes the structure.

“The note is kind of attractive, but the tenor puts me off a little bit,” he said.

“The Dow is more concentrated than the S&P, but those companies are the cornerstone of the U.S. industry. I’m always going to need that U.S. equity exposure. It’s my core allocation, so I have no problem with the underlying.”

But Kunhardt said he does not like notes that are “that long,” referring to past experiences.

“I did seven-year notes in the past, and I kind of regretted it. I felt like I was hamstrung in my allocation.

“Typically now, we don’t do longer than five years.

“And this is an eight-year one. The only time we went that long was for limited partnerships, which I don’t do anymore.

“At some point down the road, I kind of regretted locking myself up for that long when there are zillions of other opportunities.

“I like the note, but it’s just too far out.”

Tenor and risk

Michael Kalscheur, financial adviser at Castle Wealth Advisors, has a different take on the length, but his conclusion is also negative. He said he buys longer-dated products and even likes them because market risk decreases over long periods of time. As a result, he uses those long-term notes as a way to control risk and enhance the upside. However, the GS Finance note offers the opposite of such expectation: little upside enhancement and a downside protection that may be in excess of what is really needed, therefore ending up being too pricy a trade-off.

“Anytime you get to the principal-protected securities, conservative clients love it,” he said.

“But eight years is a long time when you only get one-to-one on the upside with a cap on top of it.”

Back testing

Kalscheur picks his notes using back testing data and probabilities of losses and gains.

While he does not have data on the Dow Jones industrial average, he has collected return figures for the S&P 500 index since 1950. He considered the two benchmarks close enough to base his estimates on the S&P 500 rather than on the underlying Dow.

“I lean very heavily on historical rates of return. If I look back since 1950, cumulatively, over an eight-year period, the S&P 500 has been down 8% of the time. I don’t want to trivialize that, but don’t forget that you don’t get the dividends with the notes,” he said.

The dividend yield on the S&P 500 is about 2%. Over the eight-year term, investors “lose” about 16% in unpaid dividends, he noted.

“If you invested in the index instead of the notes, the index could be down 16% and you would break even because of the dividends.

“Now if I go back to my stats, how often in the past 67 years has the index lost 16% or more? Well, within an eight-year trailing period it has only happened 1.8% of the time, in other words almost never.

“This full downside protection only protects me less than 2% of the time.”

Upside probabilities

Kalscheur then looked at the upside potential. The notes offer no leverage. Investors therefore are not compensated for the loss of dividends. In addition, the cap limits the potential return. He assumed the maximum payout of 200%, which is par plus a gain of 100%.

According to his data, there is a 56.5% probability for the S&P 500 to finish between zero and 100% during an eight-year trailing period. Adding the two probabilities – 8% on the downside and 56.5% between the initial price and the cap – leaves investors with a remaining 35.5% chance of “being capped out,” in other words to get a lower return than the index because the cap is lower than the market return.

“The chances of underperforming on the upside are nearly a third,” he said.

“Half the time you’ll make what the market does, no more, because it’s one-to-one and you still lose the dividends. So you end up underperforming as well.

“It’s only in 8% of the time that investors outperform, but that is without taking [into] account the loss of dividends.

“If I include the dividends, I beat the index only 1.8% of the time.”

Costly trade-off

“It’s very hard to go in that long and give up the upside for the principal protection,” he said.

“I understand where they’re coming from. It looks very good. Everybody wants downside protection.

“But statistically speaking, on an eight-year period, the chances of losing money are slim, really slim if you stick to your guns. So why pay for a full protection?”

The protection costs investors not having any leverage and seeing their gains limited to the cap.

“If I’m going to be tied up for eight years, I want at least a good chance to beat the market, and this note doesn’t offer that.”

Goldman Sachs & Co. is the agent.

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

The securities will price on March 27 and settle on March 30.

The Cusip number is 40054KXX9.

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