Goldman Sachs, Morgan Stanley to price notes tied to EEM aimed at risk-tolerant, value players

By Emma Trincal

New York, Feb. 21 – GS Finance Corp. and Morgan Stanley Finance LLC are readying issues linked to emerging markets in response to value-oriented investors hoping to capture higher returns from an underperforming asset class and seeking to diversify away from a U.S. market that many see as already overbought.

Each upcoming offering has a three-year maturity and is linked to a commonly used exchange-traded fund. The structures are capped and buffered.

The first one offers no leverage, but its cap is higher and its buffer is wider than the second one.

GS Finance plans to price 0% buffered notes due March 4, 2022 linked to the iShares MSCI Emerging Markets exchange-traded fund, according to a 424B2 filing with the Securities and Exchange Commission.

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

If the ETF return is positive, the payout at maturity will be par plus the ETF return, capped at 45%. Investors will receive par if the ETF declines by 15% or less and will lose 1% for every 1% that the ETF may decline beyond 15%.

Morgan Stanley Finance will issue 0% buffered Performance Leveraged Upside Securities due March 25, 2021 linked to the same ETF, according to an FWP filing with the SEC.

The notes are guaranteed by Morgan Stanley.

The payout at maturity will be par plus 200% of any fund gain, capped at 125% to 130% of par. Investors will receive par if the fund falls by up to 10% and will lose 1% for each 1% decline beyond 10%.

Bullish versus range bound

Because the Morgan Stanley notes showed a cap quoted in a range, sources used a hypothetical midpoint at 127.5% of par. On that basis, the maximum return would be 8.5% per year on a compounded basis versus 15% for the Goldman product. However, the chances of reaching this high single-digit target would be high with a mere 4.4% annual growth rate.

“You have to decide if you’re bullish on emerging markets or if you see it moving sideways,” said Steve Doucette, financial adviser with Proctor Financial.

“The second deal is really for someone who has a range-bound view.

“You’re only going to outperform if the emerging markets don’t move up more than 5% a year. And on the downside, you can’t be down by more than 10%. It’s a narrow range. I’m always surprised when people make those range bets .... especially with emerging markets, a highly volatile asset class.”

The next bull market

He noted that many research platforms have turned bullish on emerging markets due to the steep losses incurred in some of those countries, including China, which is the top constituent of the fund.

More volatility in China and other countries such as Turkey last year have created pockets of value. For aggressive investors, lagging performance spells more opportunities.

“Many smart folks on the Street are saying that it’s the only asset class that will provide real returns over the next seven to 10 years,” he said.

“Emerging markets stocks are cheap compared to U.S. stocks. With the run-up in the U.S., the market is not going to see real profits. You have to go where you can get the best returns.”

A terrible year

Emerging markets in 2018 had a “really bad year,” he said, down 15% versus a 4.5% loss in the S&P 500 index.

Part of the problem came from China, which fell into bear market territory under the double whammy of trade tariffs and slowing growth.

China represents 31.5% of the iShares MSCI Emerging Markets ETF.

For the year to date, the S&P 500 has gained 11% versus the ETF’s 8.9%.

“Even when you’re expecting them to come back, they’re still lagging. You have to be patient, but I believe in reversion to the mean. The only place you’re going to get returns is going to be in those markets, not in the U.S. Therefore, I don’t want to cap my returns on emerging markets,” Doucette said.

A third way

This would eliminate both notes since both products are capped while giving the advantage to the Goldman Sachs deal, whose cap is much higher. However, the higher cap comes with a one-to-one upside participation, which Doucette said he would reject.

“I would have to get a little bit of both deals,” he said.

“The cap on the second one is too low, but I like having the leverage. I would want to raise the cap in order to get maybe 10% a year,” he said.

This would mean a cap of about 35% versus the 27.5% hypothetical midpoint level.

“For this I would be willing to give up some leverage, but not all of it. I don’t want zero leverage. I’d have to find something between zero and two times ... maybe it would be 1.5.”

Finally, Doucette said he would want to hold onto the existing protection level.

“I’d try to stick to the 15% buffer. I might give up a little bit of it to get a higher cap.”

Obtaining a higher potential return, safeguarding the downside and enhancing the return with some leverage were his conditions, all of which reflecting a strong yet cautious bullish outlook.

“I would have to get my terms. But I couldn’t work with the low cap. You don’t want to miss a potential rally, especially over the next three years. I do expect emerging markets will come back.”

Too much risk

For Matt Medeiros, president and chief executive of the Institute for Wealth Management, the choice was easier.

“I don’t like either,” he said.

Medeiros was more concerned about the risk associated with the volatile asset class.

“I’m not a fan of either one of those. The buffers do not allow for enough downside protection. When you’re talking about emerging markets, even a 15% buffer on a three-year is not sufficient,” he said.

“Getting access to emerging markets through a structured note is generally a good idea. But we see a lot of headwinds right now, in particular the dollar appreciation.”

As the notes are tied to an international fund, investors in the notes are subject to currency risk. Any weakening in the local currencies will erode the returns.

In addition, some emerging market countries with heavy amounts of dollar-denominated debt may be exposed to additional risks that could negatively impact their economies.

“From an economic perspective, from a geopolitical perspective there are a lot of headwinds that cause concerns,” he said.

“Having the constraints of a cap and a small buffer wouldn’t be appealing to me.”

Goldman Sachs & Co. LLC is the underwriter of the first deal, which will price on March 1. The Cusip number is 40056EXL7

The agent for the second deal is Morgan Stanley & Co. LLC. These notes will price March 22, and the Cusip number is 61768DR64.

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