Goldman Sachs’ leveraged notes linked to Russell 2000 index use geared buffer to raise cap

By Emma Trincal

New York, June 6 – Goldman Sachs Group, Inc.’s 0% capped leveraged notes linked to the Russell 2000 index offer a reasonable risk-adjusted return for investors willing to take extra risk with a geared buffer, said Tim Mortimer, managing director at Future Value Consultants.

The expected maturity is 24 months, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is positive, the payout at maturity will be par plus 1.5 times the index return, up to a maximum return that is expected to be 19.5% to 22.5% and will be set at pricing. If the index return is negative, investors will receive par if the index drops by up to 10% and will lose 1.111% for every 1% index decline beyond the 10% buffer.

Downside leverage

“This is a leveraged buffered note with a downside gearing of 1.11. Because the buffer is 10%, this 1.111 multiple is the highest you could have to get the index to zero,” Mortimer explained.

A standard 10% buffer would expose investors to a maximum loss of 90% while gearing can lead to the loss of the entire initial investment, he explained.

“By increasing the gearing from 1 to 1.111, you add more value because there is more risk sold to the investor. That extra risk translates into extra premium, which can be used on the upside,” he said.

He offered an example of the additional risk incurred by investors compared to a long-only position.

“If the Russell is down 30%, you are 20 points below the buffer, which gives you a 22.22% loss. You’re still better off than the index,” he said.

“If the benchmark finishes down 60%, you are 50 points below the buffer, you lose 55.55%. Still better off than being long the index.

“There is more risk but not a lot more than a standard buffer. Yes, it’s enough to give you more to play with.

“The idea is to extract extra premium from the buffer multiple. On the downside, it’s 11% more than one for one.

“You sell the put struck at 90. The premium will finance the call spread used for the cap. The put price is what scales up the return.”

Call spread

Mortimer explained that the cap is just the output of the other fixed parameters that are used to define the product.

“You want a note on the Russell. You want a 10% buffer. It’s two-year with a 150% upside participation. Now you have to price it. You look for the put price that matches these parameters. The cap will be determined by the amount of premium you get from selling the put,” he said.

Leverage and cap are priced using a call spread.

“The spread is to be long 1.5 times an at-the-money call and short the call at a higher strike to wherever the cap is,” he said.

The issuer comes up with a cap range of 19.5% to 22.5%.

When dealing with a range, Future Value Consultants by convention picks a value situated 25% below the upper range. The hypothetical cap in this case would be 21.75%.

With the predefined leverage factor and maturity, a 21.75% cap means that the index has to grow by 14.5% in order to enable investors to maximize their return. This level represents for the noteholder the equivalent of a 10.34% annualized compounded cap.

Raising the cap

“This product is for somebody who wants exposure to the U.S. small-cap equity market and would be happy with a 10.35% return per year,” he said.

“The lower the cap, the cheaper it is to structure the product.”

One way to avoid lowering the cap too much is to use the downside gearing, which is the mechanism used in the pricing of this product, he said.

“The effect of the 11% downside gearing gives you an extra 1% in premium, which can be used on the upside to increase the cap. So you get more on the upside but with a little bit more risk. That’s how this product has been structured,” he said.

The issuer also uses the dividends paid by the index to buy the options. In this case, the Russell 2000’s 1.3% dividend yield is less than other indexes such as the S&P 500, which pays 1.85% in dividends, and the Euro Stoxx 50, whose 2.65% yield is even higher.

“But for two years, what you don’t get in dividends is not that significant. On the other hand, you are gaining much from the implied volatility of the underlying,” he said.

The two-year implied volatility for the Russell 2000 is 20% versus 15% to 16% for the S&P 500.

“The higher volatility will give you more premium for your put, which is good. So you may not gain much on the dividends, but you get a lot from volatility,” he said.

Defensive first

Despite the rationale of increasing the cap by raising the value of the premium, the notes are mostly defensive in nature, said Mortimer.

“The reason for using this note is not to just get a high cap but to provide exposure to the Russell with protection. It’s a reasonably defensive play,” he said.

The risk as measured by Future Value Consultants is slightly lower than that of the average leveraged return note recently rated by the firm.

The riskmap is 3.09 versus an average of 3.22 for comparable products.

The riskmap is Future Value Consultants’ measure of the risk associated with a product on a scale of zero to 10 with 10 as the highest level of risk possible. It is the sum of two risk components: market risk and credit risk.

Return, price scores

“The product also shows a pretty average return score,” he said.

The return score of the product is 7.25 versus 7.73 for the average of products of the same type.

The return score is Future Value Consultants’ measure on a scale of zero to 10 of the risk-adjusted return of a note.

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 market assumption for this product is bullish.

While close to average, the return score for the product is still slightly lower than the average for the category.

“We find slightly higher fees coming out of the Russell compared to the S&P. The return score is tightly related to the price score, which is the way we gauge the value of the product,” he explained.

The price score measures the value to the investor on a scale of zero to 10 with 10 as the best possible value.

The notes scored 7.29 on the price scale versus 7.60 for the average score for products of the same type.

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

“The return score follows the price score. If you spend less, the return will be less,” he said.

“We could also have a slightly lower return score due to the extra gearing on the downside.

“It’s a possibility because the geared buffer can create slightly higher losses. That could hurt the return score, which is quite sensitive to big losses.”

Overall score

The notes have a 7.27 overall score versus 7.66 for the average.

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

“For someone looking for a product to invest in the Russell, this note offers a perfectly reasonable and valid choice,” he said.

Goldman Sachs & Co. is the underwriter.

The Cusip number is 38147QSF4.

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