GS Finance’ digital notes tied to Euro Stoxx 50 index emphasize protection, analyst says

By Emma Trincal

New York, April 8 – GS Finance Corp.’s 0% digital notes due Oct. 12, 2017 linked to the Euro Stoxx 50 index, are characterized by a low risk level perhaps to the detriment of the return, making this product more likely to appeal to bearish and risk-adverse investors than bulls, said Tim Vile, structured product analyst at Future Value Consultants.

The notes will be guaranteed by Goldman Sachs Group, Inc.

If the index return is greater than or equal to negative 15%, the payout at maturity will be the maximum settlement amount of $1,080 per $1,000 of notes, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will be fully exposed to any declines beyond 15%.

Absolute return

The note offers a positive return even if the index declines within a small range, Vile noted.

This makes the product slightly different from more commonly seen digital notes, which pay a fixed return when the index finishes above the initial price.

“This one pays below the initial price. It’s a bit different. You get something more than just the protection. But you pay for that,” he said.

“It allows you to outperform on the downside. But if you’re bullish, your 8% return over 18 months is not very exciting.”

If the index dropped 15%, investors would outperform the market by 23%, he noted.

“It’s only in this type of bearish scenario that your note is really profitable. But for a bullish investor getting 8% or 5.3% a year is not much.”

Investors in the notes do not receive dividends. The yield on the Euro Stoxx 50 index is 3.20%, he pointed out.

As a result an investor buying the product would give up 4.8% in dividend yield or nearly 5% to just get 8%, he noted.

“This is pretty much geared towards the bears. It doesn’t make much sense if you’re bullish, even if you’re moderately bullish. You would be better off investing in the index directly,” he said.

Future Value Consultants in its research assesses risk, return and price using a variety of proprietary scores in order to compare a product with others.

Low risk

For the risk, Future Value Consultants produces its own metrics, the riskmap, which measures the risk on a scale of zero to 10 with 10, the highest level of risk possible. This measure of risk is the sum of two riskmap components –market risk and credit risk, both calculated on the same scale.

The market riskmap of the notes is only 1.62 compared to 4.57 for the average of the same product type, which is “digital”, according to Future Value Consultants’ research report.

“This is a very low level of market risk. It’s the buffer that contributes to this result,” he said.

On the credit risk scale, the notes with a 0.52 credit riskmap are in line with an average of 0.56 for the product type.

“Given the short tenor, the credit risk should have been lower. But the creditworthiness of the issuer probably pushed up the risk. One factor offset the other to give you an average,” he said.

Goldman Sachs and Morgan Stanley are among U.S. banks those with the widest credit default swaps at the moment at 114 basis points and 113 bps respectively, according to Markit. In comparison, CDS spreads for Bank of America and Citigroup are both at 105 bps and JP Morgan is at 80 bps.

The riskmap, after adding the two risk components is 2.14 versus 5.13 for the product type.

“This is very good. But this is also what defines the product. It’s all about reducing risk. It’s very defensive,” he said.

Return and value

The risk-adjusted return as measured by the return score was disappointing.

The notes showed a 6.83 return score versus 7.24 for the average digital note.

“It’s very low risk. That should help. But it doesn’t really help because your upside is very low,” he said.

The score suggested that the issuer could have raised the upside even on the basis of the low risk level.

For each product, Future Value computes a price score that measures the value to the investor on a scale of zero to 10.

This rating estimates the fees taken per annum. The higher the price score, the lower the fees and the greater the value offered to the investor.

At 7.87 the price score is higher than the average of 5.99 for the same product type, the report showed.

“It’s interesting. It shows that you can have a mediocre return score and yet your product can still offer good value,” he said.

“You get a buffer and you get 8% return even if the index is down 15%. Those two things are expensive.

“The issuer spent a lot of money for those options. The note offers a chance to beat the benchmark by 23%. That’s a lot on the downside even if the payout is not so high.”

The final score in the report is the overall. It consists of the sum of the price and return scores. Future Value Consultants uses it to provide its final opinion on any given product it rates.

Fair

The overall score is 7.35 versus an average of 6.61 for similar products and 6.30 for all product types.

“The price score helped a lot. This is a decent overall score. While this product is not so much for bulls, it still works for a particular type of investor. If you’re more conservative, if you want to limit your risk and make money in a correction scenario, this product can be a good option.”

Goldman Sachs & Co. is the agent.

The notes (Cusip: 40054KAH9) are expected to settle on Wednesday.

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