Goldman Sachs' leveraged buffered notes on Euro Stoxx 50 may appeal to the strongly bullish

By Emma Trincal

New York, Oct. 4 - Goldman Sachs Group, Inc.'s 36- to 40-month 0% leveraged buffered notes linked to the Euro Stoxx 50 index, offer above-average risk-adjusted return mainly because there is no cap on the upside, said Eve Berlinska, structured products analyst at Future Value Consultants.

As such the notes should be attractive to investors who are aggressively bullish on the eurozone benchmark, she added.

If the index return is positive, the payout at maturity will be par plus 1.25 times to 1.35 times the index return, according to a 424B2 filing with the Securities and Exchange Commission.

If the index declines by 15% or less, the payout will be par. If the index declines by more than that, investors will lose 1.1765% for every 1% that the index declines beyond 15%.

The exact upside participation rate will be set at pricing.

"This is a leveraged note linked to a relatively common underlying. About 40% of the deals we have recently reviewed were based on the S&P 500 and 25% on the Euro Stoxx," she said.

The Euro Stoxx 50's implied volatility of 21% is slightly higher than that of the S&P at 17%, she noted.

"The most positive aspect of the structure is that the return is not capped," she said.

"When investors consider leveraged return notes, they tend to be only mildly bullish because their return expectations should not exceed the cap, she said.

"But here, we want the market to grow as much as possible. This is for investors who expect strong market movements."

"Among the negatives is the downside leverage factor that can actually generate a loss of your entire principal," she said.

"Also the three-year maturity is on the longer end of the range for leveraged notes, as those are usually between 18 months and two-year."

Future Value Consultants in its research assesses risk, return and price using a variety of proprietary scores in order to compare a product with others.

Higher credit risk

One of them is the riskmap, which is Future Value Consultants' measure on a scale of zero to 10 the risk associated with a product, with 10 the highest level of risk possible. It is the sum of two risk components: market risk and credit risk.

The notes have a 0.98 credit riskmap compared to 0.65 for the average of the same product type. The same product category in this case represents all leveraged notes with or without downside protection and with various maturities.

"The credit risk is greater because it happens to be a longer tenor. The creditworthiness of the issuer is not so much of a factor here. It's mostly due to the duration. Goldman Sachs' five-year credit default swap spreads are 60 basis points, which is not very high compared to other U.S. banks," she said.

The market riskmap for the notes is 2.68 versus 2.73 for the product category.

"It's about average despite the buffer. Let's take into account the fact that the Euro Stoxx is a little bit more volatile than the S&P.

"Also, a lot of these leveraged notes, as we said, have shorter tenors.

"Finally, the downside gearing has a negative impact and does increase the market risk. If we run the model with exactly the same terms, the same underlying and the same issuer but use, instead of a geared buffer, a one to one exposure beyond the buffer, the market riskmap would drop to 2.36, which would be much better than average."

When comparing the market riskmap to all the recently rated notes, whose average market riskmap is 3.90, the notes show a greater degree of safety, she said.

"This is because the general group includes a significant number of reverse convertibles. Those are mostly tied to stocks, which as we know are much more volatile," she said.

Because the credit risk is higher than average and the market risk only average, the product shows a 3.67 riskmap, which is greater than the average leveraged product riskmap of 3.38, according to the report.

Return score

Future Value 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.

"Our best scenario here is bullish since we have unlimited upside," she said.

The return score of the notes is 8.41 versus 7.69 for the average of the same product type.

"The risk-adjusted return being offered given the risk investors are willing to take with this product is terrific. The issuer is paying you more than average and this is essentially because there is no cap," she said.

The issuer however did not finalize the maturity of the product, stating in the prospectus a term ranging between three and 3.33 years, she said. The same uncertainty applied to the leverage factor comprised between 1.25% and 1.35%.

By convention and in order to compute its reports, Future Value Consultants always chooses the shortest maturity in the range, which is three years in this case. For the leverage factor, the hypothetical value would be 1.325% as the rule is to pick a value 25% below the higher end of the range, she said.

"The return score could vary if those two parameters changed. We've run our report based on the shortest possible maturity and the leverage factor is higher than mid-point.

"Should the issuer price the product as a 40-month instead of 36-month and use the 1.25% factor for the leverage, the results may be quite different," she said.

Price, overall

For each product, Future Value computes a price score that measures the value to the investor on a scale of zero to 10.

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 has a 7.69 price score, which is in line with the average of its peers at 7.86, she said.

"This tells us that the issuer spent a decent amount of money on the options. Another factor is the underlying, which is not complex and fairly liquid," she said.

Overall score:

The notes score 8.05 on the overall scale versus 7.77 for the average of the same product type.

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

"The score indicates that we have very good value in this product.

"The notes are a good option for the very bullish investor. Unlike leveraged notes with a cap, this product eliminates the risk of underperforming the underlying index if you don't take into account dividends," she said.

Goldman Sachs & Co. is the underwriter.

The Cusip number is 38147QXN1.

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