Goldman’s leveraged buffered notes linked to MSCI EAFE designed for defensive, long-term bet

By Emma Trincal

New York, Aug. 12 – Goldman Sachs Group, Inc.’s 0% leveraged buffered notes linked to the MSCI EAFE index target investors who want equity exposure but are worried about current market valuations, said Tom Balcom, founder of 1650 Wealth Management.

The notes are expected to mature 60 months after pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 1.3 to 1.4 times any index gain. The exact participation rate will be set at pricing. Investors will receive par if the index falls by up to 25% and will lose 1.3333% for every 1% that it decline beyond 25%.

Getting exposure

“If you have a client who is a long-term investor but who is worried about investing now, at these levels while the market is at a peak, this might be a good solution for them,” Balcom said.

“This trade is for skittish investors who are worried about current levels. For those investors, it makes sense because the notes provide a cushion on the downside.

“In five years, if the market is down 25%, you can tell your client, ‘you have no loss of principal.’ That’s a great conversation to have.”

The five-year tenor means the notes would be a poor choice for investors who need liquidity, he said, given that structured notes may or may not offer attractive secondary market pricing compared to the original issue price.

True buffer

“This is for a long-term bullish investor who wants to play it safe,” he said.

“The buffer definitely offers a lot of value. If five years from now the market is down 30%, you end up with 93 cents on the dollar instead of 70 cents on the dollar, which is pretty good.”

According to the prospectus, a 30% loss would cause noteholders to lose 1.3333% for every 1% that the index declines in excess of 25%, or 1.333% times 5%. As a result, investors in the notes would incur a 6.65% loss and get roughly 93% of their principal back as opposed to a 30% loss for the long-only investor.

One drawback for the noteholders, he said, is the absence of dividend payments. The dividend yield of the MSCI EAFE index is 1.7%.

“You’re not getting the dividends. For the sake of simplicity, let’s say you’re losing 2% a year, or 10% total. Say the market is down 25%. A long-only investor would lose only 15%. You on the other hand would have no loss of principal. That’s significantly better,” he said.

“The upside offers return enhancement. Combined with the buffer, this type of product constitutes the potential replacement of a long-only exposure for someone who wants downside protection and who is not worried about the credit risk associated with Goldman Sachs.”

Long tenor

Yet the five-year duration is not for everyone, he said.

“I personally think five years is too long,” he said. “One of the drawbacks is that clients see the performance of the index at any time. If it’s up 20% on the first year, they ask why they don’t see it in the statement. And if it’s down 10%, they wonder why the buffer has not been applied yet.

“The benefits of the notes – leverage, protection – all that comes into effect at maturity only. In the meantime, you have to manage clients’ expectations. Some investors don’t understand the point-to-point payoff, and with a five-year maturity, advisers have some explaining to do.

“In addition, the upfront fees make it more difficult to sell before maturity. The client not only has to be a long-term player. They have to understand how the payout works.”

No income

For some advisers, complexity is the main drawback.

“It’s so different from the way I would normally invest. I am a long-only equity guy,” said Greg Werlinich, president of Werlinich Asset Management, LLC.

“If you want exposure to this index and write call options against it for the next five years, I wonder if you wouldn’t be better going long-only. You would have the income from writing the calls, the income from the dividends and the full liquidity. You may achieve better returns than if you’re being locked up for five years having no dividends.”

However, the outcome would depend on the final index performance. In some cases, investors may be better off with the notes, even without dividends, as they benefit from the uncapped leveraged exposure on the upside, he noted.

“If you have the belief that the EAFE will do better five years from now, it might be a way to play it. You have to be comfortable with the credit risk, although I’m not worried about the risk from Goldman. If Goldman goes under, we’ll have bigger problems. But the key is that you have to be willing to have an illiquid investment,” he said.

KISS principle

Despite some of the benefits of the payout, Werlinich said he would not be comfortable showing the notes to a client.

“Clearly, it’s a very sophisticated product. It would have to be for investors who really understand what it is they’re getting into. For retail investors, it probably is not appropriate because of the complexity of the notes,” he said.

“If you have a larger portfolio and if you’re looking for exposure to foreign markets, it might be a way to go.

“But the complexity alone might be a turn-off for me. I like to keep things simple, stupid ... the KISS principle, if you will.

“In 17 years as a business owner, I’ve never had a legal complaint against me, and I’d like to keep it that way. If I buy Apple and it’s down 20%, I’m not likely to be sued. It may be slightly different when selling derivatives like this.”

Goldman Sachs & Co. is the underwriter.

The Cusip number is 38147QER3.

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