Goldman Sachs' trigger notes tied to S&P 500 index have short maturity but risky barrier type

By Emma Trincal

New York, Dec. 12 - Goldman Sachs Group, Inc.'s 0% trigger notes due June 17, 2015 linked to the S&P 500 index feature a one-to-one exposure to the index with contingent protection, but advisers said that the type of barrier may be too risky for a structure that lacks any return enhancement. The advantage of the product, however, is its relatively short tenor, they noted.

The trigger level is 78.7% of the initial index level, according to a 424B2 filing with the Securities and Exchange Commission.

If the index's closing level remains at or above the trigger level throughout the life of the notes and the final index level - which will equal the average of the index's closing levels on the five trading days ending June 12, 2015 - is greater than or equal to the trigger level, the payout at maturity will be par plus the greater of zero and the index return.

If the index closes below the trigger level on any day during the life of the notes or the final index level is less than the trigger level, the payout at maturity will be par plus the index return. If that return is negative, investors will receive less than par.

American barrier

The American option used for the downside trigger is a concern, advisers said.

An American barrier option is one that can be exercised any day during the life of the notes. The opposite - and the standard barrier used in most structures - is the European type of option, in which the observation takes place once, usually at maturity.

The "trade-off" in the deal is to use a less protective American-option type of barrier in order to reduce duration and eliminate the cap, sources said. But they added that they remain cautious about the downside given a potential pullback in stocks and the way the trigger is monitored on a daily basis, which increases the odds of a barrier breach.

"With the volatility of the market, you can lose that protection very easily, just when you need it," said Steve Doucette, financial adviser at Proctor Financial.

"The average bear market is 20%. When your protection is 21.3%, it doesn't give you much of an edge.

"You are long this index for some protection level until you burst that barrier. And it can happen any day during the term of the deal.

"When I look at deals, I want to outperform the benchmark either on the upside or on the downside."

Closing average

One positive feature, however, is the five-day closing average at the end of the term.

"It makes a lot of sense here, especially with this type of barrier. It gives you a little bit more protection, although it's not much," he said.

"When you think about it, for most notes, it's a luck of the draw to look at the index only on one day.

"You could have a protection and you burst the barrier on the last day. The averaging might get you out of this.

"We've done a couple of deals with averaging, and I kind of like the concept.

"Five days though is still not much."

In order to counter some of the risk induced by the American barrier, he suggested a longer observation period.

"Why not putting a 30-day or 40-day averaging? It would help a lot [to] reduce the odds of bad news," he said.

"Volatility could really pick up. If you look at historical charts, the market can move up or down 1% to 2% every few days. But in times of crisis, it's more like 1% to 7%.

"On the upside, you only have a one-to-one participation. So you're not going to outperform the benchmark.

"I guess it's designed for people who don't believe we'll have a pullback, or they don't think it's going to be too bad. They're OK being long the market."

Complexity

For Matt Medeiros, president and chief executive at the Institute for Wealth Management, who remains relatively bullish on the S&P 500, the American barrier is more of a problem in terms of complexity.

"I like the S&P. It had a very good run this year, and valuations are still very reasonable. I like the opportunities in the S&P over the next 12 to 18 months. We don't anticipate that the market is going to go up at this phenomenal pace looking forward. In fact, we do see a little bit of a selloff towards the end of this year due to the tremendous amount of appreciation we just had. But I don't anticipate that a market sell-off would trigger the barrier," he said.

"Obviously, I would be more comfortable with a final barrier. But the downside protection level seems fair to me in this relatively short period of time."

Medeiros said that his main objection to this type of barrier is its complexity.

"I'm not a huge fan of the American barrier," he said.

"You already have too many moving parts here with two types of observation points. The trigger could be hit any day or at maturity or both. Depending on where the index finishes, you could end up with no losses even if at some point the trigger is hit - that's when the index is up at maturity. Or if the S&P closes down but above the trigger, you could still lose money because at some point earlier the barrier was breached.

"I would prefer a simple barrier, especially with something that conceptually is very simple. I prefer simple terms, simple structures."

Shorter version

Goldman Sachs also plans to offer a nearly identical deal, only six months shorter and with a few differences.

The issuer's 0% index-linked trigger notes due Dec. 30, 2014 tied to the S&P 500 also include the American barrier. The trigger is 83%, which represents 17% of contingent protection, according to a 424B2 filing with the SEC. The payout will be the same except for two differences: a 15% upside cap will be applied whether the trigger is hit or not, and the product does not use an averaging feature.

With this version, the issuer was able to shorten the product, but the trade-off is not all that appealing, said Doucette.

"They kept the American barrier, and they took out the five-days closing average. In addition to that, they cap your upside," he said.

"Again, the average bear market is a 20% decline. If you observe it daily, a protection of 17% isn't much, especially if you have a cap of 15% on the upside.

"This is an unlimited downside with a limited upside. We don't usually like this type of payoff."

Goldman Sachs & Co. is the underwriter and JPMorgan is the placement agent for both offerings.

Both notes are expected to price Friday and settle Wednesday.

The Cusip number is 38147Q6A9 for the 18-month, uncapped note and 38147Q5W2 for the one-year security.

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