GS Finance’s notes tied to iShares MSCI EM, Euro Stoxx add worst-of payout to digital

By Emma Trincal

New York, Feb. 2 – GS Finance Corp.’s 0% digital notes due Aug. 23, 2019 linked to the iShares MSCI Emerging Markets exchange-traded fund and the Euro Stoxx 50 index “for a change” feature a worst-of that does not come with an autocallable feature, said Suzi Hampson, structured products analyst at Future Value Consultants.

If the return of each underlier is at least negative 25%, the payout at maturity will be between 110.10% and 111.10%, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will lose 1% for every 1% decline of the lesser-performing underlier from its initial level.

“It’s unusual to see a worst-of product without the autocall,” she said.

The large majority of worst-of are income-generating products that offer a coupon on a contingency basis, according to data compiled by Prospect News. The coupon barrier is typically at a lower level than the call trigger, which is at par, she explained.

Alternatively, some leveraged notes occasionally come out with a worst-of payout.

“But these are rare, too. Basically, almost all worst-of are autocallables that pay a coupon,” she said.

Same concept

She explained however that this note while not an autocall offered similarities with “kick out” products.

“If you think about it, it’s pretty similar to an autocall. We could have run our simulation on it using just one single call point,” she said.

“The concept is the same: you’re getting a fixed payment based on a trigger level whereas with leverage your return is based on the actual performance of the worst-of.”

The remaining difference was the fixed maturity.

“Investors know the notes will mature,” she said.

Only two ways

Future Value Consultants offers stress test reports on structured notes. Each report contains 29 tests or tables.

Five distribution assumption sets are included in the firm’s report. They represent five market scenarios, which are based on volatility as well as different growth rate assumptions. Those are bull, bear, less volatile and more volatile. In addition, a neutral scenario is the basis of the simulation in all reports. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

One of the tables in the report, called capital performance tests, shows the simplicity of the product outcomes. Only two outcomes can occur: investors receive the digital amount if the worst-performing index finishes above the barrier; or they lose money if it doesn’t.

“The probability of getting just your money back between the barrier and par is zero here,” she said.

Just don’t fall

In a neutral scenario, investors have a 77% chance of making money versus 23% of losing, according to the table.

The probabilities of gains increase in the “less volatile” market scenario to 84%. This result, quite slightly lower, is in line with the 87% probability seen in the bull market.

“There is no real advantage for the underlying to increase with this product. You don’t need to be above the initial price. You just need to stay away from the barrier, but it’s a low barrier. That’s why between the less volatile market and the bull you get quite similar probabilities,” she said.

Payment odds ‘pretty high’

Looking again at the neutral scenario with its 77% chance of getting more than capital, she said that the chances of getting paid were “pretty high” in this conservative assumption.

“That’s a combination of things. Your barrier is quite defensive. Any index return above it will trigger the payout.

“And a 10.6% return is not too bad, but it’s not huge on an 18-month.”

Hampson used a digital of 10.6% as a hypothetical rate of return to run the report. It is the midpoint of the range.

“You have a high probability of getting a moderate return. That’s how the product is built,” she said.

“It’s always a balancing act. Either you can increase your chance of a lower return or you have a lower chance of having a higher return. You won’t have it both ways.”

Correlation

The issuer used the worst-of to add more risk premium and improve the terms, she said.

The correlation between the two underlying indexes is 72.4%.

“The assets are not terribly uncorrelated, but still, it’s riskier than using just one index.”

The use of the emerging market and European benchmarks also appears to be riskier than other typical pairs of indexes.

For instance, the Russell 2000 and the S&P 500, which are commonly used in worst-of deals, have a higher correlation at 86%.

The higher the correlation between the underlying in a worst-of, the lower the risk is.

“If the issuer had picked two more correlated indexes, the terms would have had to change,” she explained.

“But the lower correlation in this deal allowed for more spending on the return or the barrier, probably the barrier.”

Biggest losers

The capital performance tests table displays average payoffs by outcomes for each market.

For the “return more than capital” outcome, all scenarios naturally show the same 10.6% average return given the fixed payout.

On the negative side, the lower losses in average are seen in the bull scenario and the less volatile scenario. Both happen to have the same 37% average loss, according to the table.

Conversely the bear market and more volatile market generate the worst losses on average: 44.7% and 44.3%, respectively.

“Here again you have similar probabilities between the bull market and low volatility assumption. The same is true when you look at the similarities of losses between the bear and the volatile markets,” she said.

“All you want is to not breach the barrier at maturity. So that explains those similarities.”

Back testing

Future Value Consultants also runs back testing analysis.

Not surprisingly, the frequency of getting more than capital over the past five years is very high at 95%. In comparison, the frequency for the past 10 years, which still include the financial crisis, is lower at 87%.

Those results are better than those in the simulation, she noted.

“It’s in part due to our conservative growth assumptions in our forward-looking estimates. Also we know that in the last five years we haven’t had any major downturn,” she said.

Low volatility bet

Investors considering the notes would have to be looking for a target income, not growth, she said.

“The fixed payout has the same appeal as the coupon in an autocall. It’s just not income. You just have a single point at maturity. It takes away the risk of getting your money back when you’re not ready for it,” she said.

But the market views of investors considering the notes and autocallable note holders are virtually the same.

“You are happy with the maximum return because you expect the market to be pretty flat. You certainly don’t anticipate the bull market momentum to extend for another 18 months; otherwise you would want to participate in it.”

“All you want is a fixed return. It’s a note that’s designed for a range bound market.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. is the underwriter.

The notes will price on Feb. 16.

© 2015 Prospect News.
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