Goldman Sachs’ buffered notes linked to equity basket lose some of their appeal due to length

By Emma Trincal

New York, July 10 – Goldman Sachs Group, Inc.’s 0% 48-month buffered basket-linked notes tied to a basket of two indexes and one fund offer an attractively sized buffer on the downside, sources said. But the less appealing upside combined with the long maturity made two buysiders cautious or even skeptical about the trade.

The basket consists of the S&P 500 index with a 45% weight, the iShares MSCI EAFE exchange-traded fund with a 35% weight and the Russell 2000 index with a 20% weight, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus any basket gain, up to a 40% to 45% cap. Investors will receive par if the basket falls by up to 20% and will lose 1.25% for every 1% decline beyond 20%. The exact cap will be set at pricing.

Gearing is OK

Steve Doucette, financial adviser at Proctor Financial, said that he is comfortable with the underlying basket as well as the buffer despite the downside gearing.

“The leverage on the downside doesn’t bother me here,” he said.

“Sometimes it’s harder to explain to investors, but the reality is you add gearing to increase the upside, and with a 20% buffer, you’re still ahead of the curve. Without the gearing you would have less attractive terms, so why not take the little excess risk?”

An example in the prospectus showed that a noteholder would lose 6.25% of principal as a result of a 25% decline in the basket level. As the underlying decline grows, however, the compounding induced by the 1.25 leverage factor would progressively reduce the benefit of the buffer. For instance, if the underlying were to fall by 50% at maturity, investors in the notes would lose 37.5% of their investment.

Incomplete blend

Doucette said that the underlying basket is “not bad,” although he prefers to stick to one asset class per note.

“I don’t have a problem with the globally diversified basket except for two things. You’re mixing international and U.S. equity in one instrument. We usually break these allocations in pieces,” he said.

“I don’t mind at all the 35% allocation to international. Most asset allocators will put 10% to 30% in international equity even though non-U.S. stocks represent 50% of the market capitalization of the world.”

But Doucette said that one asset class is missing.

“As asset allocators, we tend not to blend everything in one note. But if I’m blending, I’d have to add the emerging markets component,” he said.

Duration, however, is a bigger problem, he argued.

“The real concern with the notes for me is not the downside leverage, it’s not really the basket, but it’s the duration. I don’t like the four-year [term],” he said.

“We tend to do two-year, sometimes maybe 15-month. A three- to four-year is about the maximum we would go out, and we would do a four-year if we had to replace a note because volatility is not the same unless you purchase longer-dated maturities. But that would be in that context, not for a new investment.”

Buffer and duration

The downside buffer is the best part of the deal, but the length of the product reduces its appeal, he noted.

“There is a problem with the value of the protection over a four-year period,” he said.

“There is very little value if the market is down a year from now. Longer term, we don’t really know what the value of the option is going to be. It is what it is. We ask issuers to model the value of the notes as you go out, but when you go that far out, you’re only going to get an estimate of the price of the option, nothing really tangible. Therefore I’m not sure about the value of this buffer. It’s not like you’re buying these notes the way you would buy a put. These notes are designed to be held at maturity anyway, so you’re stuck with a four-year product not knowing when the pullback is going to happen.”

Market cycles

Probabilities based on market cycles and history would point to a pullback occurring sooner rather than later, however, he noted.

“As we’re entering a six-year bull market, the odds of getting a pullback over the next 18 months are significant,” he said.

“That’s when the four-year term doesn’t help. If the market sell-off happens early on, chances are it might come back before the notes mature, in which case the value of your buffer is gone. And since this is the only real benefit offered by the structure, that’s a problem.”

Bears outperform

Doucette said that he selects notes based on their capacity to generate alpha, or returns in excess of the market, which is why he sees the value of the notes in the buffer rather than on the upside.

“This product is good on the downside. The upside doesn’t give you anything,” he said.

“If the market is up, you can’t outperform because you have no leverage. And if it’s up a lot, if it’s up above the cap, you are guaranteed to underperform.

“In other words, if the market rallies, you either have no edge or you underperform.

“The only way you can outperform is if the index is down. You can only beat the market if there’s a sell-off. Looks like a bearish note to me. I don’t know how you can look at it any other way; otherwise, you might as well be long the index. Why cap yourself unless you expect a pullback?”

Structure is fine

Kirk Chisholm, principal and wealth manager at NUA Advisors, finds the structure of the notes appealing, including on the upside. The longer duration, however, is also his main concern given what he perceives as a risky market environment amid the unwinding of the Federal Reserve’s accommodative monetary policy.

“The construction of the notes is fine, but four years is a long time,” Chisholm said.

“The cap on the upside is reasonable in my opinion. It’s about 9% a year compounded.

“On the downside, a 20% buffer is nice. If there is a sell-off within the next four years, it should be sufficient.”

Yet, no one can predict the impact on stock prices of the Fed reversing years of its easy money policy, he noted.

“There is so much uncertainty around the level of interest rates a year from now,” he said.

“We know now that QE will end in October. Expectations regarding interest rates are that the Fed will start to raise rates between April and June of next year. If that happens, the risk is too high to invest in a four-year note. We’ve had the stimulus, the zero interest rate policy for so long; it’s hard to predict how the market will react when all this comes to an end. You could see a major sell-off.

“In addition to that, the S&P is definitely overpriced, so I wouldn’t [want] to buy the U.S. market at this point.”

Far too long

Despite the product’s attractive buffer and cap, the long tenor induces too much risk, he noted.

“This note is fine if you assume that the market is going to be stable over the next four years,” he said.

“Assuming we don’t have a black swan, the downside buffer is going to be sufficient. There’s a 40% to 45% cap on the upside. I’m comfortable with it. I don’t expect the market to climb more than that in the next four years. The cap is reasonable.

“But if you’re concerned about the end of QE and the rise in interest rates, if you think a significant sell-off is possible due to the unwinding of a six-year zero interest rate policy, then the notes are too risky because four years is far too long. Nobody knows what’s going to happen in four years.”

The Cusip number is 38147QCY0.

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