Goldman Sachs’ trigger notes tied to S&P 500 show longer tenor as tradeoff for no-cap, barrier

By Emma Trincal

New York, Feb. 23 – Goldman Sachs Group, Inc.’s 0% trigger performance securities due Feb. 28, 2020 linked to the S&P 500 index combine protection on the downside and uncapped and levered upside, but the five-year term is advisers’ main focus and in some cases main objection.

The payout at maturity will be par of $10 plus 131% of any index gain. The exact participation rate will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 25% and will be fully exposed to losses from the initial index level if it falls by more than 25%.

“It’s very straightforward. It’s a reasonably attractive note with some challenges,” said Steven Foldes, vice-chairman of Evensky & Katz / Foldes Financial Wealth Management.

Challenges

“The first challenge is the five-year because it’s a long period for us. We typically don’t like to go out more than two or three years.

“Goldman Sachs to us is a good name. We certainly use it for other notes. The credit is not a big issue for us.

“The uncapped return is a good thing. Getting 131% participation is better than 100% especially without a cap.

“There is a barrier for the protection. We prefer buffers but we understand that pricing is a function of buffers versus barriers.

“The fact that you have a nice protection on the downside, leverage on the upside without a cap, this is all good.

“Our problem is to have our money tied up for five years.”

Conversation

“We understand that a lot depends on the underlying. Even when there is a lot of volatility, the S&P is frequently considered to be the best underlying. The terms are not as favorable as other asset classes such as U.S. small caps, emerging markets, real estate or commodities notes,” Foldes said.

“There is a challenge for banks creating notes on the S&P 500.”

Foldes said that if he was “serious about the note” he would consider having a “conversation” with the issuer in order to see how to shorten the duration.

“You would be looking at either reducing the levered upside and/or reducing the barrier on the downside. Is it a 20% barrier? A 15% barrier? If we wanted a shorter-dated product, we would have to see what the upside and downside protection look like. It may not be attractive. If you give up the downside barrier and if the upside is so modest that it’s just as easy to own the index fund then it wouldn’t work.”

Dividends

Foldes said that when comparing the notes with the fund, credit risk exposure was not the only factor to consider.

Investors in the notes will not receive the 1.90% dividend yield of the S&P 500 index for five years, he said.

“You have to look at leverage versus giving up the dividends. You’re definitely giving up something for something.”

In some cases, the solution is to choose a more volatile underlying index.

“If you take U.S. small caps or emerging markets you may get something closer to what you’re looking for in terms of finding a balance between good terms and keeping it short,” he said.

The next pullback

Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments LLC, said his main concern was current market valuations.

“The S&P 500 is such an incredibly popular index if you look at the inflows right now, you can certainly assume that we’re heading into a big drop. The S&P is higher than it has ever been in a very long time. We could have a worse bear market than in 2007,” said Kaplan.

Risk and rates

The 2007-09 bear market began in October 2007, turning into a bear market in 2008 with a 20% decline.

By March 2009 when the trend was over, the benchmark had lost 57% of its value since its last peak in less than one-and-a-half years.

Today’s market presented similar risks along with new risks in the context of low interest rates, he said, pointing to the U.S. five-year Treasury yield of 1.55%.

“It’s a global phenomenon when you think that U.S. Treasuries actually offer more yield than other government bonds in Europe,” he said.

The trend has led traditional income investors to tap into equity for better returns.

“Conservative savers have moved their money from the banks to the stock market. Right now they’re making money but if the market goes down, the biggest damage will hit those who have allocated to equity with little or no experience and without knowing how to handle volatility.”

Cycle

In that regard, the long-term duration was an advantage in his view.

“At least the fact that it’s a five-year term is not so bad in this context. We are more likely to see a correction or a bear market sooner than later. After five-years, we may be better off because bear markets don’t last five years, they last two years, two-and-a-half years. If investors hold the notes until the end, there may be enough time for a portfolio to recover from a downturn.”

By choice, as a contrarian investor, Kaplan said he would feel more comfortable investing in a note tied to an “unpopular” index. With time, prices would be likely to rebound from their current low levels.

“The S&P is overvalued, overbought. If you’re investing on a five-year time horizon, it makes more sense to go into other asset classes that are not in favor. Crude oil, commodities, gold, emerging markets like Brazil, Africa or South America are at six-year lows. You would have a much better risk-reward if you had a structured note tied to some of those markets.

“Show me a one-year note on commodities or emerging markets with no cap. I would find it quite interesting,” he said.

The notes (Cusip: 38146U108) will settle on Thursday.

Goldman Sachs & Co. is the underwriter.

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