Goldman Sachs' buffered digital notes tied to Russell 2000 target risk-averse investors

By Emma Trincal

New York, Sept. 20 - Goldman Sachs Group, Inc.'s 0% buffered index-linked digital notes due Sept. 29, 2016 tied to the Russell 2000 index are not designed to capture for high returns but rather are aimed at investors who need to reduce potential pitfalls in their investment, said Suzi Hampson, structured products analyst at Future Value Consultants.

"This is a lower risk product for mildly bullish investors," she said.

"Given that, investors should not expect very high returns and yet, our scores indicate that the notes offer below average return potential even when factoring in the low risk factor," she said.

If the index finishes at or above the initial level, the payout at maturity will be a fixed return of 17.5% to 19.5%, with the exact maximum return to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by up to 20% and will lose 1% for each 1% that the index declines beyond 20%.

The product belongs to the digital note structure category, she said. Future Value Consultants generates reports designed to assess the quality of a product compared to two groups - the rest of the market ("all products" category) and notes with a similar structure, or digital products in this case ("same product type" category), she explained.

Digitals

"Digital notes have been around for a long time. The structure is very popular and straightforward. It's similar to an autocall in that you don't require much movement from the underlying," she said.

"Both products are named 'target return' products in our methodology. Rather than looking for the benefit of growth of the underlying, the idea is to get a fixed payment based on some conditions which in this case would be the final closing price of the underlying above 100. The initial price threshold for the digital payout is quite standard. Sometimes you see it lower than 100 but it's not in the majority of the cases."

The three-year maturity was "mid-range" for the structure type, with most digital products having a tenor ranging from one to five years, she said.

The 20% buffer offered "good value," she said.

"Of course you can't judge a buffer by its size without taking into account the term and the underlying asset. But we often see 10% while 20% is rather unusual. At first glance it looks good. You obviously have to look at the distribution of returns and the probabilities of losing capital in order to make a fair assessment," she said.

Independently of the size, the nature of the protection offered was the most attractive, she added.

"Compared to American or European barriers, the buffer is the most valuable form of downside protection. In addition, there is no downside gearing on this buffer. Anywhere beyond the 20% buffer your loss is going to be one for one. So if the final index level is at 70%, you would lose 10% rather than 30% in a non-protected instrument."

The 17.5% to 19.5% digital payout was more difficult to evaluate due to its not-yet determined value. When dealing with a term expressed in a range, Future Value Consultants, in order to generate its reports and scores, uses a conventional hypothetical value situated 25% below the upper end of the range.

"We've assumed a digital payout of 19% for this product. A simple calculation gives you 6.33% a year. We definitely have products out there offering much higher returns," she said.

She compared digital notes with capped leveraged products.

"In both cases they offer a cap or a cap equivalent. Digitals can be seen as highly geared leveraged products. In this case, for instance, if the Russell is up 1%, you get 19%. It's the equivalent of a highly geared leveraged product. As digitals push the gearing to high levels, your return is going to be typically lower than with a leveraged note. The idea is that you're always getting the cap because the gearing is so high."

Playing it safe

The typical investor in the product would be someone willing to give up gains above the 19% digital payout in exchange for a buffer against the first 20% loss in the index, she said.

"Somehow we're dealing with the same type of investor who would use a capped leveraged note. They both want exposure to the asset class and are willing to go up to a point. In this case, since you don't have any participation, they're not investing for growth. Investors in this product are only mildly bullish. If your maximum gain is 6.33% a year, we're not exactly talking about a headline return. However, you do get the 20% buffer and that's the trade-off," she said.

"Obviously, this is for relatively conservative investors.

"You're sacrificing the potential higher return for the lower risk, essentially.

"With that, you have the usual structured products limits - you get the credit risk to consider, you must forego dividends and it's pretty much a buy-and-hold product for three years. These limitations are common to all structured products, not to this one individually only. But in exchange you get exposure to a well-recognized index with downside protection and outperformance over the index in the case of limited growth.

"This is not a particularly bullish product. If you were bullish, you would be looking at the fund or a structured note with a return tied to the index growth. There is no need for growth in this product," she said.

Riskmap

The key metrics of risk, returns and price are measured through various scores, which are established by Future Value Consultants.

The first one is the riskmap, a measure on a scale of zero to 10 of the risk associated with a product, with 10 being the highest level of risk possible.

The riskmap is the sum of two risk components: market risk and credit risk.

The riskmap for the notes is 3 versus 3.69 for the average of the same product type, according to Future Value Consultants' research report.

"It's quite below the average, but the credit risk is slightly more," she said.

The notes' credit riskmap is 1.01 versus 0.71 for the average in that structure category.

"The higher credit risk is due to the maturity, which is slightly longer than average. The issuer's credit default swap spreads could also contribute to this. Goldman Sachs' five year CDS spreads are 208 basis points versus 107 [bps] for Bank of America and 89 [bps] for JPMorgan," she said.

But the low market risk score more than offsets the higher credit risk.

"You're looking at a very low market riskmap - one-and-a half point below the average of all products and one point below the average for the same product type."

The market riskmap for the notes is 1.98. It is 3.45 for all products and 2.98 for the average digital product.

"The reduced market risk derives from the 20% buffer. The volatility of the underlying index could be a factor too but not as much," she said, adding that the implied volatility for the Russell 2000 and the S&P 500 was 19% and 16%, respectively.

"It's quite similar. Volatility would be a main factor if this index was meaningfully less volatile than the S&P but it's not the case, they're about the same. However some digital products are tied to more volatile indexes than both the S&P and the Russell. Also, we find from time to time digital notes linked to single stocks, so volatility may partially be a contributing factor although the buffer remains the main driver."

Return, price

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions - neutral assumption, bull and bear markets, and high and low volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios. The best assumption for this structure would be low volatility.

The notes received a 6.81 score on the return scale compared with 7.42 for the average of the same product type.

"You have a lower riskmap, which is great, but from here and up, the product is not really performing that well," she said.

"A lower risk is not really enough. For a product to be competitive, it also needs a competitive return. You don't expect to have as high a return as a risky product but the return should be comparable to that of a product with the same risk profile.

"This low return score suggests that the return offered is not quite enough given the amount of risk. The return score for this product is a bit disappointing. However, if what investors are looking at is the least risky product for that particular index or structure type, they may be inclined to choose this particular product."

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 score, the lower the fees and the greater the value offered to the investor.

The notes have a price score of 6.67 versus 7.27 for the average digital category.

"It's a bit disappointing too. It simply indicates that there was not enough spent on the assets. The return score and the price score don't always move in line, but these two do," she said.

Overall score

Future Value Consultants, with its overall score, offers its opinion on the quality of a deal. The score is the average of the price score and the return score.

The overall score for the notes is 6.74. In comparison, the score is 7.35 for the same product type.

"It's not brilliant. The notes overall don't score well at all. We see on our chart a lot of products with that kind of risk that show higher overall scores," she said.

"Each investor makes informed decisions based on what they're looking for, and that's not limited to our ratings," she said.

"For this one, the main goal is to reduce the risk as much as possible.

"Our scores just show that based on those terms, investors could have expected a higher potential return.

"But there are a limited number of offerings. You have an element of 'what's available out there.' Investors have several criteria in mind before choosing a product. They may have requests for a particular underlying, issuer etc. You can't always base your decision on one factor," she said.

The notes (Cusip: 38147QTE6) are expected to price Thursday and settle Sept. 30.

Goldman Sachs & Co. is the underwriter.

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