GS Finance’s leveraged notes tied to MSCI EAFE index show big buffer for risk-averse investors

By Emma Trincal

New York, Sept. 4 – GS Finance Corp. plans to price 0% leveraged buffered notes due Sept. 28, 2023 linked to the MSCI EAFE index, according to a 424B2 filed with the Securities and Exchange Commission.

The notes are guaranteed by Goldman Sachs Group, Inc.

If the index return is positive, the payout at maturity will be par plus 1.15 to 1.25 times the return, with the exact participation rate to be set at pricing.

If the index falls by up to 30%, the payout at maturity will be par. Otherwise, investors will lose 1% for every 1% decline beyond the 30% buffer.

Tradeoff

“This is a note for the more cautious investor. You get a pretty big buffer in exchange for giving up a lot of dividend,” said Tom Balcom, founder of 1650 Wealth Management.

The MSCI EAFE yields 3%.

“With a 30% buffer you’re playing defense. You’re getting a little bit of leverage, which hopefully can compensate you a little bit for giving up such a high yield. But it’s not going to be enough, and anyone buying this note should know they may be underperforming the total return index.

“It’s a tradeoff and it only makes sense for a conservative investor.

“This is not a bull play. It’s a very defensive note.”

Up and down

To illustrate his point he used a hypothetical example, in which the total return of the index at the end of the five-year term would be 50%. The dividends would represent 15% over the five-year term and the price return, 35%.

Investors in the notes would earn at maturity no more than 43.75%, which is the product of the price return and leverage factor, assuming the issuer picks the 1.25 level.

“I don’t think people would complain too much about it. But it’s still not the same as getting 50% when you’re long the index, he noted.

“This investment will impact the upside, and it’s very likely that you would underperform,” he added.

On the downside, however, the buffer would allow investors to outperform the index.

“If you own the index and it’s down 30%, you take a 15% loss. But with the note, you lose nothing.”

The 15% dividends would cushion the losses, reducing them half-way. But the buffer would offer twice more in protection.

Flat market

The notes would “work” in some scenarios but not in others, he noted. A range bound market would not be a good outcome for investors in the product.

“You would underperform the most in a flat market,” he said.

“That’s where the loss of dividends would hurt you the most since you’re paid based on the price appreciation of the index, not the total return.

The long tenor could bring a risky scenario, in which investors would be trailing the index significantly, he said.

“If we have a pullback followed by a recovery over the five-year period, this note wouldn’t work. We could finish relatively flat and since you don’t have much leverage and zero dividends... that would be a drag.”

So there is upside risk, he warned.

“But you don’t buy the note to beat the market if it rallies. You buy it for the downside protection,” he said.

Insurance policy

Donald McCoy, financial adviser at Planners Financial Services, agreed.

“You’re always going to be underperforming the index on the upside. You’d have to get 100% return over the next five years to basically match the loss of the dividend,” he said, assuming a leverage factor of 1.15, which would give noteholders a 115% gain.

“That’s a strong performance over the next five years.”

The note is especially designed for risk-averse investors, he noted.

“Over a five-year timeframe it would be unlikely that you would be under water. But people are worried about a pullback right now. Valuations are high. This buffer gives them peace of mind. It’s the insurance policy that you pay with the dividend.”

Euro yields

Such structure would have been difficult to replicate on a U.S. benchmark, for instance the S&P 500 index, he noted.

Terms tend to be better with European indexes because they pay higher dividends, he added.

The MSCI EAFE index, which tracks the performance of non-U.S. developed countries, is not a European benchmark. But it allocates more than 60% to European markets.

In comparison the yield on the S&P 500 index is 1.85%.

“If you didn’t have the loss of 3% dividend yield, you wouldn’t get the 30% buffer,” he said.

“If you’re bullish on international stocks, you just own the index.

“But if you’re concerned about risk management, downside protection, taking the buffer by giving up the dividend... that would be the way to go.”

Goldman Sachs & Co. is the agent.

The notes (Cusip: 40055QWT5) will price on Sept. 25 and settle on Sept. 28.

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