Goldman Sachs’ leveraged notes tied to Euro Stoxx 50 show some risk, decent cap for mild bulls

By Emma Trincal

New York, Sept. 25 – Goldman Sachs Group, Inc.’s 0% leveraged notes linked to the Euro Stoxx 50 index are designed for moderately bullish investors willing to take on risk, said structured products analyst Tim Vile of Future Value Consultants.

The notes are expected to mature between 18 and 21 months after pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus three times any positive index return capped at between $1,246 and $1,288 per $1,000 principal amount of notes. If the index falls, the payout will be par minus an amount proportional to the index’s decline.

Cap

“This is not one of those low-cap leveraged notes. It has a decent upside,” said Vile.

He explained that he chose the mid-point of the range for the cap at 26.7%. The term used to generate the research report was 18 months, the lower end of the range.

“With three times the upside and a 26.7% cap over this 18-month period, you get an annualized cap of 17.09%, which is quite high,” he said.

“This note would outperform the index as long as the index grows below 17% a year. You only need the index to be up 8.9% over the 18 months, or 5.93% a year, which is a realistic target.”

Volatile index

Assuming the deal would price on Friday, a look at the recent chart of the index confirmed that the desired level of growth has been reached only recently.

“The Euro Stoxx has been going up and down most of the year. Since last week it has already dropped 4%,” he said.

The index closed at 3,113 on Friday. In order to reach the cap, the benchmark would have to close at 3,390 in 18 months, or about 8.8% higher than Friday’s close, he noted.

“The index happened to be at this level just about a month ago. There is enough movement in the index to easily get to the required level,” he said.

Mildly bullish

The notes, however, have a risky profile.

“On the downside, there is no protection in this product,” he said.

“Each point of index decline is one percentage point of loss for the investor.

“Obviously you have to be comfortable with the risk.”

The best type of market outcome was a mildly bullish scenario, he said.

“The investor has to be bullish in order to sustain that level of risk. At the same time, it doesn’t take much index growth to outperform given the leverage. A more bullish investor would probably have selected something with a higher cap and less leverage,” he said.

“It’s quite easy for this index to be up nearly 6% a year and hit the cap. Obviously if the investor had higher growth expectations he wouldn’t settle for that cap.

“You have to be reasonably bullish to tolerate the fact that there is no downside protection. But you also have to be worried that the index won’t rise enough. That’s the type of market view an investor would have when buying this product.”

Higher risk

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

The firm scores the risk associated with a product by adding two risk components, market risk and credit risk. The resulting riskmap measures risk on a scale of zero to 10 with 10 as the highest level of risk possible.

For the market risk component, the notes showed a 4.55 market riskmap versus an average of 3.28 for the same product type, according to Future Value Consultants’ report.

The notes belong to the leveraged return category, according to Future Value Consultants’ methodology.

The credit riskmap on the other hand is lower than average at 0.47 versus an average of 0.56 for similar products.

“The higher market risk is because there is no buffer and no barrier. We’re comparing this product with other leveraged return notes. A majority of notes in this product type are linked to the S&P. The fact that the Euro Stoxx is much more volatile than the S&P is definitely an additional risk factor,” he said.

The implied volatility for the Euro Stoxx 50 index is 27% versus 19% for the S&P 500 index.

“You can easily reach your cap on the upside, but you’re also taking quite a lot of risk at the moment,” he said.

“It may be a good thing that the index recently dropped. It may give investors a nice entry point. But you never know if it’s going to drop more. And this index can show wide moves both up and down over short periods of time.

“The credit risk is low. That’s probably due to the short maturity. Most enhanced return notes have a longer duration than just 18 months.”

The riskmap, which adds both components, is 5.02 versus an average of 3.84 for similar notes.

“This result is driven up by the high market risk. The lower credit riskmap helps a little but not enough. We end up with a riskmap that’s significantly higher than average,” he said.

Return score

Future Value Consultants measures the risk-adjusted return of each product with its return score. The score is calculated using five key market assumptions: neutral, bullish, bearish, high volatility and low volatility. The best of the five scenarios is selected to measure the risk-adjusted return on a scale of zero to 10.

With this product, the best scenario is bullish.

At 7.10, the return score is lower than the 7.86 average for the leveraged return category, according to the report.

“It’s reasonable. Not bad. Not good. The cap is decent, but it’s not the best return score. So I think we can attribute this result to the fact that you have no downside protection. The significantly higher risk ends up bringing down the return score,” he said.

Price score

For each product, Future Value Consultants 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 notes have a 6.03 price score while the average for the product type is 6.16.

“It’s average really even though you have an aggressively priced maximum return of 26.7%,” he said.

“But the fees may have taken out some of the value.

“Also, it’s a short note. We calculate the fees per annum and you don’t get to spread out the fees over a very long time.

“The upside is not the issue. The issue is really the fact that you don’t have any barrier or buffer. It’s quite risky.”

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.

The overall score is 6.56 versus an average of 7.01 for similar products.

“The return score takes the overall down. The return score itself suffered from the higher risk level. But it’s still a solid score. It’s still an attractive proposal to a lot of investors,” he said.

“There is definitely a market for a product that can give investors almost 27% over one and a half years. It’s quite aggressive. If you have the risk appetite for it, if you want to keep your investment relatively short term, this is not a bad product.”

Goldman Sachs & Co. is the agent.

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