Goldman Sachs' five-year leveraged buffered notes tied to S&P 500 offer competitive profile

By Emma Trincal

New York, June 7 - Goldman Sachs Group, Inc.'s 0% leveraged buffered notes due 2018 linked to the S&P 500 index are competitively priced for investors looking for an alternative to a direct equity investment, said Suzi Hampson, structured products analyst at Future Value Consultants.

If the index return is positive, the payout at maturity will be par plus 1.2 to 1.3 times the index return. The exact participation rate will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls by up to 25%, the payout will be par. Investors will lose 1.3333% for every 1% that the index declines beyond the 25% buffer.

"This product is an alternative to a tracker fund but with a slightly different risk-return payoff," Hampson said.

"You don't get a one-for-one exposure. You get slightly more with the gearing on the upside. However, you don't get any dividends. You do have a 25% buffer, but in exchange, you're locked in for five years and you're subject to the issuer's credit risk."

The 1.33 leverage that accelerates losses past the 25% buffer was not as negative as it appeared to be, she said.

Alternative to a tracker

"The buffer is 25%. The 1.33 gearing will take you down to zero if the index was going down to zero. Most of the time, buffers have the one-for-one downside. This one has a little bit of leverage. But it's still much better than a barrier," she explained.

"Take for instance a drop in the index of 30%. With this product, you would only lose 6.665%. Meanwhile with the equivalent barrier, your loss would be 30%. It's when the index gets below the buffer that you're going to start to underperform. It really catches up with you when the index drops substantially. When it's just below the buffer, you're still outperforming."

Hampson said that the downside leverage was one of the tools used by issuers to offer more downside protection in a low-interest-rate, low-volatility environment.

"If there was no leverage, your buffer would not be 25%. It would be much smaller. That's the trade-off," she said.

Extending the maturity to a five-year term was another way to offer more protection, she said.

"It makes sense that you would get better terms on a five-year with rates being so low. At the same time, you should expect a better buffer with a longer term because the issuer has more room to play with," she said.

The longer maturity also enabled the issuer to offer a return with no cap and some slight leverage of about 1.25, she said.

"Usually, the trade-off for investors in leveraged notes is to get a decent amount of protection through a soft barrier rather than the straight buffer," she said.

"Here, you're getting a hard buffer, but you are also extending the maturity more than average. In addition, you're also getting the uncapped, geared upside. If you don't take into account the dividends that you're not getting, this note should give you an opportunity to outperform the index."

Investors who may find the product appealing would be those seeking equity exposure but without investing directly in the asset class, she said.

"The target market for this note would be similar to that of a U.S. equity fund. It's just a different risk-return profile," she said.

"The credit risk obviously would have to be taken into account, especially on the longer maturity like five years where it becomes more of an issue."

Lower risk

Future Value Consultants rates the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

At 3.18, the product's riskmap is lower than the 3.43 average riskmap of products of the same type, she noted.

"You have less risk than average here. It's mostly due to the 25% buffer, which goes a long way toward reducing risk in general," she said.

"Also, the volatility of the S&P 500 is quite low at the moment. If you look at all leveraged products, there is a certain proportion of them linked to other funds that are substantially more volatile than the S&P 500.

"With the combination of a decent buffer and a less volatile underlying, you would expect to be at the lower end of the risk spectrum for that product type, and that's what you have."

The product also shows a lower riskmap than the average of all products, which stands at 4.01.

"That's probably due to the fact that you're comparing it with reverse convertibles, which constitute the majority of the deals in numbers. The prevailing number of reverse convertibles tends to skew the average," she said.

The market riskmap is also less than the average for this category of product and less than the average for all products. The explanation remains the same: the combination of a good buffer and a less volatile underlying asset lowers the market risk, she said.

The notes have a 1.92 market riskmap, compared with 2.77 for the average of the same product type and 3.50 for the average of all products.

In contrast, the credit riskmap of 1.26 is more elevated simply because of the five-year duration of the product, she said.

The notes show a 1.26 credit riskmap, which is more than the 0.66 average credit riskmap for the same product type. It's also higher than the average credit risk for all products, which is 0.51.

"A lot of the similar products - leveraged notes in general - show a one-year or two-year tenor. This product is much longer in duration. Goldman Sachs' [credit default swaps] look pretty much average. So it's fair to say that it is the maturity rather than the specific issuer that's causing the credit risk to be higher in this product," she said.

Return score

Future Value Consultants 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, which for this product would be a bull market.

At 8.67, the return score is greater than the average of the same product type, which is 7.46, according to the firm's report. It's also better than 6.58, the average score for all products.

"We're looking at the best-case scenario, the bullish scenario," she said.

"It's a five-year product, and we're using a high-growth market assumption. With that, you have no cap and you have some upside participation above 100%. The result is a note that can potentially generate a very high return.

"The rationale for choosing the best assumption for the computing of our return score is based on a simple premise. An investor wouldn't look to buy this product if they didn't expect the best-case scenario. That's why we use the optimal scenario. We want to share the same assumptions as the investor."

Price, overall scores

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. 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 product with an 8.63 price score offers a better rating than the 7.61 average for the same product type, she said.

"This indicates that the fees taken out are low and that the issuer spent a decent amount of money purchasing the options rather than taking out fees," she said.

"Here again, duration has an impact on the score.

"Because these products are usually between one-year and two-year, the five-year maturity in this case helps the price score since we look at the fees on an annualized basis.

"If you were going to buy a one-year product every year for five years, you would be paying more in fees than if you had bought a five-year product just once.

"The longer term always adds value for the investor."

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

"We have an excellent overall score, which is higher than the average of the same product type as well as the average for all products," she said commenting on the notes' overall score of 8.65 versus 7.54 for the structure type and 6.59 for all products.

"The return score and the overall score are very similar. They both exceed the average in a significant way," she added.

"These notes are performing well under our methodology. As far as the score goes, there is no negative indication for this product.

"The high overall score is not really a surprise. You have a price score and return score that are both above average.

"If you look at our scatter chart that shows riskmaps and overall scores for recently rated products, you'll see that this product is on the top left corner, and it's really up out there. If you compare it with other products that have the same risk boundaries, you'll see that the overall score is really high on the chart. It indicates that you are getting optimal return under similar risk assumptions.

"This product seems to be outperforming its peers. It is very competitive."

The Cusip number is 38147QAD8.

Goldman Sachs & Co. is the underwriter.

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