Goldman’s digital notes tied to S&P 500, Russell 2000 feature ‘deep protection’ strategy

By Emma Trincal

New York, Oct. 13 – GS Finance Corp.’s 0% digital index-linked notes due April 29, 2019 linked to the least performing of the S&P 500 index and the Russell 2000 index show a conservative profile which makes the product similar to a high credit risk bond, said Tim Mortimer, managing director at Future Value Consultants.

If each index finishes at or above 75% of its initial level, the payout at maturity will be the maximum settlement amount of $1,070 to $1,080 for each $1,000 principal amount, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will lose 1% for each 1% decline of the worse performing index if it finishes below the 75% trigger level.

Conservative

“This is not a terribly exciting coupon but the note is a defensive play. It is not very likely that you will get a 25% decline and if it’s down by less than that, you get a 7.5% coupon,” he said.

The research firm assumed a digital coupon at midpoint of the 7% to 8% range for its analysis of the product.

“It’s pretty low risk. Obviously there are chances of losing money. But 25% is a big barrier for 18 month,” he said.

“This is for someone who wants a deep protection and still get a decent coupon.

“It’s a very conservative, market neutral, deep protection strategy.

Probabilities of losses

The relationship between low probabilities of loss but high losses in the event of a barrier breach is established in the stress test report generated for this product by Future Value Consultants.

Each of the firm’s reports contains 29 tables or sections that form the basis of the analysis. Reports are often used as a combination of a limited number of sections depending on clients’ area of interest.

One of the most widely used tables is the investor scorecard, a simulation which consists of a number of different mutually exclusive outcomes of product performance. It shows outcome names, probability of occurrence, average return and average duration.

For this structure where the digital strike is below the initial price, only two outcomes may happen: the digital payment is made or capital is lost, Mortimer explained.

In a neutral market scenario, there is an 86.75% probability of receiving the 7.5% digital payment against a 13.25% chance of losing money. The negative scenario however shows an average loss of nearly 50%, according to the capital performance tests, another table included in the report.

“The chances of losing money are rather small. Obviously when you do lose you will lose quite a lot,” he said.

Back tested

Future Value Consultants also provides back tested results over the past five, 10 and 15 years.

While investors would lose money 9.10% of the time in the last 10 years and 8.65% of the time in the last 15, the probability of a negative outcome is 0% for the past five years, according to the back tested scorecard.

“The past five years have seen a very bullish market. The past 10 and 15 years are not quite as strong due to the fall of Lehman Brothers and the bear market. Still you have very high chances of success,” he said.

But as it is the case in the simulation, back tested results indicate that losses, while unlikely, will prove to be substantial.

A barrier breach would cause an average loss of about 40% in the past 10 and 15 years, according to the report.

Bond-like

But the profile of the note remains “low-risk” given the very small probability of such outcomes, he said.

“This is a 5% a year product. It’s very similar to a bond,” he said.

To be sure, unlike a bond, investors are subject to market risk and may lose money if one index falls by more than 25%. But such scenario, he said, may not be as risky as the necessary credit risk increase investors may need to subject themselves to if they want to obtain a similar reward.

“You’d have to go a long way down on the credit risk spectrum to see that type of coupon for this length of time,” he said.

“And if you do, the chances of default would be high. It would be extremely poor credit.”

The structured note substitutes the market risk for default risk.

“In this way this product is very similar to a bond. The risks are just not the same so it’s a bit different. But it’s still a conservative approach,” he said.

Ease of simulation

The note offers an advantage over a junk bond or other high-risk fixed-income instrument.

“You have more certainty of outcome with the structured product,” he said.

“The S&P and the Russell 2000 are the two biggest indices in the U.S. You can certainly run a simulation on both and take into account the correlation. It’s much easier to do that than it is to predict the chances of a default from a high-risk issuer,” he said.

“The decision-making process is a little bit easier for investors.”

Even if the worst-of structure is not always easy to understand due to the correlation factor – the lack of perfect correlation adds another layer of risk – it can be modeled.

“While the worst-of is a little bit more complicated, those two indexes are very correlated. And you can still do the back testing on a spreadsheet.

“You can’t do that with a corporate bond.

“This gives the investor in the structured note a definite advantage.”

Goldman Sachs Group, Inc. is the guarantor.

Goldman Sachs & Co. LLC is the agent.

The notes will price on Oct. 20 and settle on Oct. 27.

The Cusip number is 40054LUZ5.

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