Goldman’s leveraged buffered notes linked to index basket: small but good deal, advisers say

By Emma Trincal

New York, July 28 – Goldman Sachs Group, Inc.’s $2.91 million of 0% leveraged buffered basket-linked notes due July 30, 2019 tied to a basket of equity indexes, which priced last week, caught some advisers’ attention for the contrast between the quality of its structure and the tiny size of the issue.

The basket consists of the S&P 500 index with a 55% weight, the Russell 2000 index with a 30% weight and the S&P MidCap 400 index with a 15% weight, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 1.27 times any basket gain. Investors will receive par if the basket falls by up to 20% and lose 1.25% for every 1% that the basket declines beyond 20%.

We missed it

“This deal is fantastic,” said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

“If I was going to go with Goldman and say, I have $3 million to invest, I want an easy-to-understand underlying, a long-term investment horizon, a solid protection, I want it cheap, I would have been hard-pressed to design a better offering myself.”

Kalscheur said that his firm has placed about a third of its structured notes business with Goldman Sachs.

“We like them. They’ve been coming out with really good products, and this one is another example. We also like them as a credit. They fall into the credit quality we’re looking for. They make the grade,” he said.

“I don’t know how we missed this one. We would have been piggy backing it.

“This may have been a reverse inquiry for a particular client. But I would have liked to get a piece of it.

“We’re a small shop. We may not have done $3 million. We usually put in smaller sizes. We use a ladder approach, which puts some limits on our commitments.

“But for $1 million, with terms that good, I would have done it in a heartbeat.”

Kalscheur reasoned that having a relationship with an issuer may help an advisory firm land better terms.

“Maybe this offering was a small spinoff for a much larger client. They may have had a relationship with that client or with a bigger organization based on some sort of negotiation ... if you give us terms as good, we’ll do 10 of these each year, and they can scale it.

“If they’re willing to do it, companies like ours would jump on that type of relationship. I wouldn’t give them exclusive, but they would get the lion’s share of our business.

“Initially, the client probably must have been shopping around and got the best price.”

Carl Kunhardt, wealth adviser at Quest Capital Management, also noticed the small size of the offering.

“The size of this deal surprises me. That’s not even $3 million. It’s quite small,” Kunhardt said.

“I might have actually done it. What they’re trying to do is give you a broad exposure to the U.S. equity market. I might have done a higher weighting on the mid-cap and increased capitalization as I go up.

“In general, I think that with $1 million, issuers will create a note for you. We thought about it for our alternative exposure – if we can structure a note the way we want – but we figured there are plenty of notes out there that meet our needs, so it may not be worth spending the time on it.”

Basket

Kalscheur said that he really likes the terms of the notes, including the underlying, the upside, the buffer and the cost.

“I like the fact that it’s tied to a basket. I’m usually not a big fan of multiple indexes because most of the times lately, it’s a worst of,” Kalscheur said.

“While I could argue a better weighting would have been a third of each, I’m confident in this allocation because it’s easy to explain to a client.

“You could argue that there is a little bit of overlap between the Russell 2000 and the MidCap index.

“Maybe another way to do this would have been to do the S&P 500, the MidCap 400 and the S&P 600, but this is splitting hairs.

“The bottom line is this is a very understandable basket. It’s a weighting, and not a worst of.”

Both the S&P SmallCap 600 index and the Russell 2000 index are benchmarks for the small-cap U.S. equity market.

Dividends back

Kalscheur said he also likes the upside leverage. While the 1.27 factor is not particularly high, it is enough to offset the loss of dividends, he noted.

The S&P 500 index pays a 2% dividend, which structured notes investors are not entitled to receive.

“If the benchmark is up 10%, you have 2% going to the dividends and 8% to growth. Without the leverage, you would only get the growth component of the return. But because they give you the leverage, you get the dividends. You do participate in the equivalent of the 10% total return and not just in the 8% price return. They’re basically giving you back the dividends, which I love. You can go to the client and say, you’re not losing the dividends; you’re really not giving anything up,” he said.

“There is enough on the upside to make my client whole. Obviously, if the market is flat and ends up with a 2% gain after five years, this is not going to help you much. But if it’s up 10% annually, you’re going to get one to one on the total return. I like that.”

Kalscheur said he does not mind not getting the two or three times leverage seen in other products that are designed to beat the underlier’s performance.

“The reason why we’re buying these things in the first place is not to get a home run,” he said.

“We don’t like 18-month notes with triple leverage and no downside protection. We look at five-years, longer time horizons. We like the leverage, but it doesn’t have to be double or triple, although we like to get 200% participation. But if I can get half a percent of outperformance or even the same performance with less downside risk, I’ll take that all day.”

Protection

Perhaps the most attractive feature is the downside protection, given its size and the longer duration of the product, which both contributed to reduce the risk, he explained.

“On the downside, you get 20%. It’s a hard buffer. I’m a big fan of the geared downside as long as it is with a hard buffer,” he said.

“We’ve seen recently something similar, but I don’t really like it because it doesn’t protect you as well as a buffer.

“We saw a deal that gave you 60% downside participation. The loss is capped at 60%, but it’s on the first dollar, unlike a buffer when you’re protected from dollar one and protected after that for the entire length of the buffer.

“We’d rather go with the Goldman structure and take the geared ratio beyond the 20%.”

Some advisers do not like geared buffers because they find them complicated to explain, but Kalscheur disagrees.

“They leverage the downside so that they can give you better terms. You wouldn’t get a 20% buffer without the gearing. You can get a good trade-off,” he said.

“In addition to that, you have five years. That’s very good.

“From a recent study I saw, since 1980, the number of times the S&P has dropped by more than 20% over a five-year timespan was only 2.3% of the time. If the term was shortened to three years, that percentage would jump to 10.8%.

“This is the statistical proof that the shorter the time period, the bigger the buffer needs to be because the index is more volatile.

“On a five-year, I am perfectly comfortable taking a 20% buffer because the chances of breaching are very small.”

Cheap

The fee on the notes is 72 basis points, according to the prospectus.

“A 72 bps fee on a five-year is extremely competitive. It looks like the cheapest offering I’ve ever seen,” he said.

“Too bad this deal never hit my desk before it closed!

“I always get disappointed with issues that carry high fees because it takes away money from the structure. With less fees, you get better terms. This one clearly shows that you can use money in a structure and make it very attractive if you don’t charge a hefty fee. I mean, 72 basis points on a five-year ... that’s a 14 basis points fee per year. I could hardly buy the Vanguard on those indexes with 14 basis points.”

Long equity

Kunhardt said he could “have used” the notes as an “equity proxy.”

He agrees that the longer tenor is part of the conservative nature of the downside.

“The 20% buffer is reasonable,” he said.

“On a point to point, without any intermediate observation, the odds that the broad U.S. market would go down by more than 20% in a five-year period, I just don’t see. In a one-year timeframe, yes, but not on a five-year,” he added.

“If you had to select the worst five-year period in a long time, you would probably pick the 2008-13 period. First, because most people agree, 2008 was the worst scenario ever in our lifetime, but also because you have the 20% down right at the start of the period. By 2013, we were already back at the 2007 levels.

“You have in this deal a fairly hefty buffer. The odds of being lower are materially low.”

The upside is also attractive although less remarkable.

“The leverage is going to work in your favor even though it’s not a high multiple. It’s certainly better than not having any leverage at all,” he said.

Kunhardt said the notes would have found a place in his portfolio.

“I would use it as an equity proxy, as part of an equity allocation,” he said.

“Despite the buffer, I wouldn’t use it as a hedge because the three underlying indexes are fairly correlated and the correlation of the notes with the rest of your equity portfolio is also pretty high.

“I would just use it as a straight equity position that just happens to have some of the risk hedged.”

Goldman Sachs & Co. is the underwriter.

The notes (Cusip: 38147QDD5) priced Wednesday.

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