Goldman Sachs’ trigger notes tied to Vanguard FTSE EM show mixed overall score

By Emma Trincal

New York, Dec. 19 – For investors seeking exposure to emerging markets, Goldman Sachs Group, Inc.’s 0% trigger performance securities due Dec. 31, 2019 linked to the Vanguard FTSE Emerging Markets exchange-traded fund offer a very attractive risk-reward profile, but pricing is below average, said structured products analyst Suzi Hampson at Future Value Consultants.

The payout at maturity will be par of $10 plus 121% to 131% of any fund gain with the exact participation rate to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

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

Higher risk

The risk associated with the product is higher than average as measured by the riskmap, Future Value Consultants’ rating made of two risk components – market risk and credit risk. The resulting riskmap measures risk on a scale of zero to 10 with 10 being the highest level of risk possible.

The notes are compared with other products of the same type, which are leveraged return notes of all types of downside exposure and length.

The product with a 4.69 riskmap shows a higher risk level than its peers, whose average score is 3.40, according to Future Value Consultants’ research report. This result is both due to market and credit risks.

Volatility

“We see much more market risk even though there is a lower barrier with a 25% contingent protection, and that’s because the volatility of this underlying is higher than a lot of similar products,” Hampson said.

The one-year implied volatility for the Vanguard FTSE Emerging Markets exchange-traded fund is 22% versus 17.50% for the S&P 500 index.

“I wouldn’t call it incredibly more volatile, but still, it’s higher and you have a whole lot of S&P-based products in the leveraged return category.

“In addition, we do have a five-year product. When you have a 75% barrier compared with the standard two-year with a buffer of 10%, the five-year duration changes the outlook significantly.

“A 75% barrier on a two-year would be much more valuable than on a five-year. Even if this comparison is not realistic, it shows intuitively how the longer term can increase market risk.”

She said that sometimes advisers tend to consider a longer-term product as “less risky” but it is, in her opinion, a matter of perspective.

“If they have a bullish view long-term, then yes, you have more chances to see the index grow over a longer period of time. But in terms of risk, you also find more chances for the index to decline. The spread of return is greater over time and seeing it differently is only a matter of outlook.”

Credit risk

The notes also show more credit risk – the credit riskmap is at 0.79 compared to 0.56 for the average.

Goldman Sachs’ five-year credit default swaps were 85 basis points on Friday, according to Markit. The bank’s spreads are wider than average compared to other U.S. banks, such as Morgan Stanley with 82 bps; Citigroup, 73 bps; Bank of America, 66 bps; and JPMorgan 63 bps.

But the five-year duration had to be factored in since the majority of the products in the leveraged return group have shorter durations, she said.

“The term of the notes is going to be a big factor. I would attribute most of the higher credit risk to the term rather than the creditworthiness of the issuer. The longer the exposure to credit risk, the higher the score,” she said.

Return score

On the positive side, the product showed an attractive return score of 8.40 versus 7.76 for the average in the category, according to the report.

Measuring the risk-adjusted return on a scale of zero to 10, the return score is calculated by selecting among five different market scenarios (bullish, bearish, high or low volatility) the one that would yield the best results. In this case, the score has to be based on the bullish assumption.

“A structured product uncapped, with our hypothetical 128% participation rate will compensate for the non-payment of dividends,” she said.

Future Value Consultants by convention picks a value defined in a range at a 25% level below the upper range. With the 121% to 131% upside participation rate range, the value used to run the report was approximately 128%.

“This bullish assumption is exactly the scenario these notes are designed for. Returns will look very good in a bull market. The fact that volatility is higher means a good possibility for growth as volatility means wider price moves not just on the downside. As a result, investors have a chance to score very good returns.”

Less attractive was the price score of the product, which measures its value on a scale of zero to 10.

The 3.44 price score was “amazingly” below the average for the same product type, which is 7.38, she said.

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

Value

“It’s a very poor price score, which indicates that the value of the assets is not very high. In other words, the issuer may not have spent enough on the options,” she said.

“It’s interesting to note this divergence between the good return score and the poor price score. It demonstrates the relevance of having both scores.”

One factor may explain the low value: among notes offering emerging market exposure, only a few employ the Vanguard fund while the MSCI emerging market fund is used in most of the products.

“You have less competition and less transparency, which can have an impact on pricing,” she said.

One of the main differences between those two popular ETFs is that the Vanguard fund does not offer any exposure to South Korea while the MSCI fund does.

The price score is subject to change. If Goldman Sachs decides to price the deal at a higher participation rate, closer to the maximum level of 131%, the improvement on the rating would be notable, she said.

“It wouldn’t change so much the return score, which is already high. But it would improve the price score as value is very sensitive to the participation level.”

Investor rationale

The product is aimed at investors who expect bullish growth in this fund and want uncapped leverage.

“They have a specific interest in this fund, which is different from the standard one. The structure is such with the leverage and the absence of a cap that it has the potential to outperform the fund in a growth scenario. Even though the notes offer no dividend payments, the participation over five years at some point will allow investors to catch up with dividends as well,” she said.

“It’s still relatively easy for investors to buy the fund directly. The rationale for investing in the notes rather than the ETF is to get the downside protection, which you don’t have with a direct investment.

“On our scale, despite the 75% barrier, investing in this product remains relatively risky.

“But if this is the underlying index that you’re interested in, the structured note offers considerable benefits versus the fund because, for a relatively similar performance, you get this barrier.

“The tradeoff – and there has to be one, of course – is to take on the Goldman Sachs’ credit risk and lock in for five years.

“That’s the kind of decision an investor has to make.”

Overall score

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.

At 5.92, the product’s overall score is very “weak” compared to 7.57 for the average in the category.

“We have here a very good risk-adjusted return but a very disappointing price score. That’s the advantage of breaking down our overall assessment into those two components. Investors have to decide if the growth potential of the notes is worth accepting the less-than-average value.”

Goldman Sachs & Co. is the underwriter.

The notes will price on Dec. 26 and settle on Dec. 31.

The Cusip number is 38148K587.

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