Goldman Sachs’ leveraged notes tied to global equity basket bring diversification, volatility

By Emma Trincal

New York, Oct. 29 – Goldman Sachs Group, Inc.’s 24- to 27-month 0% leveraged buffered notes linked to a basket of indexes offer investors access to international equity, a more volatile asset class than the S&P 500 index, which makes the pricing more attractive, a market participant said.

The notes are designed for investors willing to take the extra risk involved with non-U.S. equity investments in exchange for protection, a buysider noted.

International basket

The basket consists of the Euro Stoxx 50 index with a 37% weight, the FTSE 100 index with a 23% weight, the Topix index with a 23% weight, the Swiss Market index with a 9% weight and the S&P/ASX 200 index with an 8% weight, according to a 424B2 filing with the Securities and Exchange Commission.

If the basket return is positive, the payout at maturity will be par plus 1.5 times the basket return up to a 17.25% to 20.25% cap. Investors will receive par if the basket falls by 10% or less and will lose 1.1111% for every 1% that the basket declines beyond 10%.

The exact maturity date and cap level will be set at pricing.

A market participant explained that the volatility of some of the index components might offset the overall impact of diversification.

“The investor is selling volatility, which allows the issuer to provide a buffer and also a 20% cap on a two-year,” he said.

Normally, baskets tend to reduce volatility because they provide more diversification, he explained, adding that it may therefore give room to raise the cap or in some cases eliminate it altogether.

“But everything is relative. While the basket may dampen volatility, what’s in there and the weightings provide enough volatility to get you relatively attractive terms. It’s international equity, and it’s going to be more volatile than the S&P 500, obviously. You have Europe, Japan. These things can move a lot. Those two together make 60% of the basket,” he said.

Pricing, terms

A similar note linked to the S&P 500 index would be difficult to cap at the 17% to 20% level, he noted. The international basket offers more risk premium.

“You have more money, and you can do more. It’s up to the investor to decide what’s good in a structure and where value is. Getting more volatility means you can get perhaps a higher cap, no cap, a lower barrier or a good buffer. It depends,” he said.

“If you look at the downside, the 10% buffer looks good compared to an S&P deal. But really 10% on two years when you think about it is not that much when you see what happened a couple of weeks ago. Interest rates are low, and people make do with buffers. Whether a 10% buffer on international stocks is good enough is up to the investor to decide.”

U.S. versus the world

Elliot Noma, founder of Garrett Asset Management, LLC, agreed that the underlying basket, despite its diversity, has more risk than an investment in U.S. large caps.

“With this structure, investors probably expect those markets not to do that well. They’re willing to give up the tail on the upside, but on the other hand, they don’t see a major disaster on the downside, which is the reason they can live with a 10% buffer. At least they get some sort of cushion,” he said.

“What I’m hearing now is that people are bearish about Europe and Japan. What’s tempering that is the ECB and Abenomics giving a sense that we’ll do what’s necessary to keep these countries from falling into the black hole.

“But Europe has political and economic problems. Japan hasn’t really got the full kick of its Abenomics yet, plus you also have the demographics issues there.”

Abenomics refers to the monetary stimulus policy put in place by Shinzo Abe, prime minister of Japan.

“China is not in high gear. Plus you have the international issues in the Middle East, Ukraine and Ebola in Africa. All of these factors mean more market turbulence,” he said.

In contrast, common wisdom attributes more stability to the U.S. markets.

“Experts right now are saying the U.S. is the best market out there. They’re also saying that they don’t expect a massive run-up because we already had it and because it’s not clear how strong the U.S. economy really is,” he said.

“But the Fed just announced that they’re still going to keep rates low, and even if the QE just terminated today, they will continue to reinvest the money, so there will be some support. The market sees that as a positive. There is nowhere else to go than in U.S. stocks, and money has to go somewhere.”

Investors in the five different international stock markets constituting the underlying basket would be pursuing a different strategy, he noted.

“They’re willing to take the extra risk in terms of volatility out there, but they’re buying insurance with the buffer and they’re willing to give up the big upside,” he said.

Goldman Sachs & Co. is the underwriter.

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