Goldman Sachs' 0% notes linked to the Dow offer 100% principal protection, five-year term

By Emma Trincal

New York, May 18 - Goldman Sachs Group, Inc.'s five-year 0% equity index-linked notes linked to the Dow Jones industrial average are designed for equity investors looking to change their exposure to risk by reducing the volatility of a long equity portfolio, said Suzi Hampson, structured products analyst at Future Value Consultants.

If the index return is 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 return is zero or negative, the payout will be par.

Five-year tenor

"This five-year note has a shorter maturity than the average 100% principal-protected note," Hampson said.

Equity-linked notes with capital guarantee have a six-year tenor on average, according to data compiled by Prospect News.

In addition, they're more often linked to the S&P 500 index, which is "slightly more volatile" than the Dow, she said.

"The volatility differential is not huge - the one-year implied volatility is 21% for the Dow Jones and 23% for the S&P 500 - but it's enough to make the economics of this deal work because the cost of the embedded call is going to be cheaper when volatility is lower," she said.

"Goldman's funding level is quite high. That's a reason they were able to put together a structure without a cap on a five-year maturity," she said.

Compared to most structured notes, five years is a relatively long term, she said, but not for a principal-protected structure.

"If you want to get a three-year product, you're going to have a cap or pick a more volatile underlying," she said.

Risk

The risk associated with the product is measured by riskmap, Future Value Consultants' rating that rates the risk associated with a product on a scale of zero to 10. The higher the riskmap, the higher the risk of the product.

The notes have a 2.61 riskmap. "It's quite low," she said. The score is similar to the 2.67 average rating for products of the same type, other fully principal-protected notes.

More significant is the comparison with all products. At 4.35, their average riskmap is much higher, she noted. The difference is no surprise, she noted, given that the all-product category includes a great number of reverse convertibles.

The riskmap is composed of market riskmap and credit riskmap.

Although the product offers principal protection, investors incur some "slight" market risk exposure because the riskmap is measured against the risk-free rate, Hampson said.

The five-year Treasury yield is 0.74%. If the notes only pay principal at maturity, the zero gain will indeed be lower than the cash-like return.

As a result, the notes score 0.61 on the market risk scale against 3.65 for the average of all products.

The credit risk, on the other hand, exceeds the average because of the long tenor.

At 2, the notes' credit riskmap is higher than 0.70, which is the average of all products. It is higher simply because of the long maturity, Hampson said.

Goldman Sachs' five-year credit default swap rates are 290 basis points, which is wider than 205 bps for Barclays but tighter than 397 bps for Morgan Stanley, she added.

"They don't have the widest spreads. Really what increased the credit riskmap here is duration," she said.

Return

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments 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. In this case, Hampson noted, the optimal market environment is a high-growth scenario since the return is uncapped.

The return score for the notes is 8.33, almost identical to the 8.30 average for this type of product. But the score is much higher than that of all products, at 6.46, she noted.

"It's the principal protection plus the uncapped return. It's easy in those conditions to come up with a higher return score," she said.

"In addition, the return score here is based off the best scenario, which is high growth.

"A high annualized growth rate with no cap during a five-year period will give you a high return score."

Price, overall

Future Value Consultants measures the market value of the underlying components of the product as a percentage of the initial investment on a scale of zero to 10 with its price score.

The notes received 9.64 on the price scale versus 6.94 for all product types.

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

The five-year tenor is also a factor for the good pricing, she said, as Future Value Consultants uses fees per annum to calculate the price score.

"Longer products always do better on the price scale," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

With an 8.99 overall score, the notes are very similar to the average of the same product type, at 8.91, observed Hampson. But when compared to 6.70, which is the average overall score for all products, these notes show a much better score.

"Principal-protected notes as a product type tend to score very well. You're buying a zero-coupon [bond] and a call. There's no reason it should cost a lot of money in terms of options. The challenge is of course low interest rates levels. A rise in interest rates would likely increase the issuance of principal-protected notes as it would make it easier to put those products together," she said.

Goldman Sachs & Co. is the underwriter.

The Cusip number is 38143U3A7.

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