GS Finance’s leveraged buffered notes tied to EAFE ETF require timing decision

By Emma Trincal

New York, Aug. 2 – GS Finance Corp.’s 0% leveraged buffered notes due Aug. 19, 2021 linked to the iShares MSCI EAFE exchange-traded fund require investors to decide whether they are comfortable with an investment that’s neither long-term nor short-term as everyone is trying to guess when the long bull cycle will finally end, a financial adviser said.

“The tough part is the term,” said Steve Doucette, financial adviser at Proctor Financial.

The payout at maturity will be par plus 1.5 times any fund gain, up to a maximum settlement amount of 45.75% to 48.75% cap, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to 20% and will lose 1.25% for each 1% decline beyond 20%.

Terms

“You get international exposure. 13% cap is pretty nice. The EAFE has underperformed U.S. markets, which is also a plus if you believe in reversion to the mean,” he said.

The downside protection was also favorable to investors.

“20% is a pretty healthy buffer even though it’s geared...A lot of people don’t like it. I do. Unlike a barrier, you don’t burst through a buffer and the gearing takes a long time to kick in. You almost have to go down to zero until you’re no longer ahead of the index.”

Doucette said he likes to be able to beat the market in both directions. The buffer made it possible on the downside.

“You’ve got a guaranteed outperformance on the downside as a result of the protection.

“And 20% is nice. It covers your typical bear market. If your timing is wrong at least you’re outperforming by 20%.”

Timing is everything

But a good structure may not be necessarily a sound investment. Doucette focused on the three-year term, unsure whether the timing was right.

“I’d look at what happens with the terms if I decided to shorten or lengthen the maturity. The idea is to get through the next cycle,” he said.

Since the structure is relatively well priced as it is, one way to modify the tenor may be to add an underlying.

“If you add a worst-of component – and I’m thinking emerging markets because they’ve underperformed – you’ll get much better terms. I’m sure you can start playing with the terms. Do I want it shorter? Do I want more protection? More leverage?” he said.

Adding the emerging markets component would still keep the investment under the same allocation.

“You’d be capturing international exposure,” he said.

“Of course, what you want to change is going to depend on your view.

“Ideally you want to increase the buffer and the cap. But how long should you be in this note?”

Having a view

For bulls, the market is not going to turn negative that quickly, he noted.

“We’re going up because we’ve got the largest GDP in years, the economy is very strong and the inflation is low. If that’s your view you might want to ride it out shorter, increase the upside and reduce the protection.

On the other end of the spectrum, some are expecting the beginning of a bear cycle in the second half of 2019.

“A lot of people are beginning to worry. We’re nine years in a bull market: it’s late in the cycle. The yield curve is so flat... they see a possible inversion soon, which signals a recession. Stocks are overvalued in the U.S. And you have this trade war going on,” he said. “If you’re in that camp, the market cycle is going to turn faster than we think. In that case you want more protection.”

Unforeseen herd mentality

While “rationally,” Doucette agrees with the bullish view, the next sell-off could be devastating if fear takes over, increasing the odds of a bear market and destroying value at a fast clip in a similar way as last week when the share price of Facebook, Inc. dropped at historical levels.

“We all think fundamentally but behavioral factors have a huge impact on the market,” he said.

“Everyone can see that we’ll have a market turn. We’re heading toward a bear market. But no one knows if it’s going to be next year, in three years, in five years. We don’t know.”

The hard decision for investors considering the notes is remaining bullish for the next three years.

“My best guess would be to shorten it a little bit, like a two- to three-year, and add protection,” he said.

“But how long really this thing should be? That’s a tough call.”

So-so deal

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the notes are just average.

“It doesn’t jump out as something I’ve got to buy right away. It’s just OK – not great but OK,” he said.

Medeiros usually does not like caps. But the 45.75% to 48.75% maximum return was reasonable for this maturity. It represents an annualized return comprised between 13% and 13.25% on a compounded basis.

“It’s not bad. The cap on this index is in line with our return expectations for this asset class,” he said.

Medeiros said he is relatively bullish on the EAFE index due to the lower stock valuations observed in the world outside of the United States, especially in Europe, which represents about 62% of the underlying ETF portfolio.

At the same time, European markets could face some geopolitical headwinds, including terrorism.

“A huge terrorist attack could impact growth in this space, so I like the 1.5 times leverage because it would help the returns,” he said.

Straight buffer preferred

What was more of a drawback for this financial adviser was the nature of the buffer.

“I like the buffer. But I’m not a fan of the gearing. I would prefer a straight buffer,” he said.

Geared buffers are sometimes unpopular as they change the nature of the risk. They put investors’ entire principal at risk even if such outcome would require a dramatic 80% plunge in the index price.

“At the same time, I don’t see anything in the timeframe that gives me pause. We don’t anticipate a scenario where this index would go through a massive correction in the next three years. Presumably, I don’t expect a strong decline beyond 20%,” he said.

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. is the underwriter.

The notes will price on Aug. 14 and settle on Aug. 17.

The Cusip number is 40055QRE4.

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