GS Finance’s unusual $1.32 million notes on S&P 500 give more than absolute returns

By Emma Trincal

New York, Aug. 8 – GS Finance Corp.’s $1.32 million of 0% index-linked notes due Aug. 3, 2027 linked to the performance of the S&P 500 index showed a very unusual payout giving two layers of positive returns if the index is negative but above the buffer level.

Despite its complexity, some advisers found the note to be appealing due to its defensive structure and potential to strongly outperform the market on the downside.

But for some bullish and bearish advisers, the index may move beyond the boundaries, within which the return is optimal, hence limiting the appeal of the investment.

If the return of the index is zero or positive, the payout at maturity will be par plus the index return, according to a 424B2 filing with the Securities and Exchange Commission.

If the index declines but not more than 15%, investors will receive par plus the absolute value of the index.

Investors will receive par plus the return of the index plus a 30% buffer if the index declines more than 15%. This will result in a positive payout if the return of the index is above 70% of its initial level. But the payout will be negative if the index declines beyond that level.

Profits on the downside

“Actually, this is a very good deal,” said Scott Cramer, president of Cramer & Rauchegger, Inc.

“It looks like the only time you lose money is below the 30% buffer. But you lose less than the index.

“If you’re above the buffer, you get a total downside protection and much more.

“Even if the market is unlikely to drop 30% in five years, you could still be down 10% and make 10%.

“I don’t know how they priced it. But it’s pretty compelling to have a positive return all the way down to the buffer even if at some point you’re eating away your profit.”

He explained what he meant by that.

Unlike the absolute return range from 0 to minus 15% where profits increase from 0 to minus 15%, the second “range” of positive returns (between minus 15% and minus 30%) will provide declining profits from plus 15% to zero, he explained.

“The index is down 20% and you get 10%. Your profit is not as high as the absolute return. But you’re still profitable,” he said.

Cramer said that the buffer employed in the note was better than any traditional buffer.

“You’re getting more than your principal back within the 30% buffer range even if your gains decline after a while,” he said.

“It’s still a profit. It’s still better than par.”

Tenor and liquidity

The main “downside” of the notes was the five-year tenor with the associated loss of dividends.

Cramer downplayed this aspect of the structure.

“It’s five years. But who cares? That’s still a great tradeoff,” he said.

Investors buying the product should just hold it until maturity because the note may be less liquid than most products, he added.

“If you want to sell it on the secondary market, you may have a hard time doing it. The bank would have to buy the options to offset the value of the notes, so you may not get a great bid,” he said.

“Say three years from now the S&P is down 10% and you want to sell it then. Your note is worth +10%. I don’t know who’s going to buy that back because they have to hedge that out. The issuer has to buy the options to hedge that.”

For protection only

On a different note, the apparent “complexity” of the deal was not an issue for Cramer.

“It’s a little bit complicated but you can explain it to a client.”

One possible “risk” associated with the note would be on the upside. If the index finishes positive, investors will only get the price return of the S&P 500. Structured note holders do not receive dividends.

“The index is likely to be higher in five years. But this should not be compared to the market. There is a lot of benefits in this note, which have little to do with upside participation. This is for someone who wants the protection. That’s the reason they’re buying it,” he said.

“I can actually think of some of my clients who may be interested in looking at it.”

Smoke and mirrors

Carl Kunhardt, wealth adviser at Quest Capital Management, did not share that view.

“This is Goldman Sachs’ proclivity to make awfully complicated deals and play games,” he said.

“When was the last time that the S&P 500 index finished negative over a five-year period? The likelihood of this is minuscule.

“So, everything having to do with this buffer is smoke and mirrors.

“It’s not a bad protection. It’s also kind of a useless protection.

“The most probable scenario over five years is that the S&P is up.

“You get 100% participation in the market, no cap but no dividends.”

“I’m giving up nearly 8% in dividend to buy a protection I probably won’t need if I’m going to be long the market for five years.”

The S&P 500 index has a 1.56% dividend yield.

It’s precisely with the dividends that the issuer is in a position to price the downside payout without having to cap the upside, a structurer said.

The pricing was achieved by combining put spreads at different strike prices with a long position in the underlying, he explained.

Costly games

Kunhardt said that in practice, the notes presented another disadvantage.

“There is another problem with this note. I have to sit for 10 minutes trying to describe it. I have better things to do than playing that game with a client. A trader might. A broker might. I am not,” he said.

Giving up dividends was too high a price for this adviser.

“Imagine showing a mutual fund to a client with an 8% fee. Add up whatever the fee is.”

The notes carry a 1% fee, or 20 basis points per annum.

“Would you ever show a mutual fund at a cost of 8.20% a year?

“If at least the protection was useful. But the probabilities just don’t back you up. It seems like an awfully expensive insurance,” he said.

Not bearish enough

For advisers with a bearish outlook, the notes naturally offer much more value. But only to a point.

“If you want exposure to the U.S. market, it’s clearly better than being long the S&P,” said Kirk Chisholm, wealth manager and principal at Innovative Advisory Group.

“Five years is a long time. But I don’t think volatility is going to decline. I expect the market to be down five years from now, so the note is clearly better than the index. From a risk-adjusted-return, it’s much better.”

Still, this adviser’s strongly bearish view would prevent him from considering the notes.

“Although I believe that it’s a better choice than being long the S&P, I still wouldn’t do this. It’s not in line with the way I manage portfolios.

“In my models, the market could be down an additional 40% to 60% from where we are. Even this note is not going to give me enough protection on the downside.

“If you expect a market decline of less than 30%, this is a good note.

“But that’s not my outlook. I wouldn’t’ use it. I use options instead,” he said.

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The notes settled on Aug. 3.

The Cusip number is 40057MMX4.

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