Goldman Sachs' autocallable buffered notes tied to Russell 2000 show good risk/reward profile

By Emma Trincal

New York, Nov. 24 - Goldman Sachs Group, Inc.'s upcoming three-year 0% autocallable buffered index-linked notes linked to the Russell 2000 index offer an attractive return potential while standing at the low end of the risk spectrum, said Suzi Hampson, structured products analyst at Future Value Consultants.

The main reason for this is the high likelihood that the notes will be called on the first call date, giving investors a potential early return of principal with a double-digit premium.

The notes will be automatically called at par plus an additional amount if the index closes at or above the initial index level on any call observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The additional amount will be 9.75% to 11.375% if the notes are called on the first call observation date, 13.5% to 15.75% if they are called on the second date, 18% to 21% if they are called on the third date and 22.5% to 26.25% if they are called on the fourth date.

The four call observation dates will be spaced six months apart, and the first one will be 13 months after the pricing date.

If the notes are not called, the payout at maturity will be par plus 27% to 31.5% if the final index level is greater than or equal to the initial level. Investors will receive par if the index declines by 30% or less and will lose 1.4286% for every 1% that the index declines beyond 30%.

Flat only will do

One positive aspect of the structure, Hampson said, is that the call trigger does not require the index to rise.

"You only need the index to stay the same on any of the observations dates for the call conditions to be met," she said.

"It's more likely to kick out than a product which requires the underlying index to grow by a certain percentage. The investor only need have a neutral view on the market as no rise in the index is required."

Another attractive part of the deal is its low risk of 2.36 as measured by riskmap, a Future Value Consultants rating that evaluates the risk associated with a product on a scale from zero to 10.

Early kick-out

"The relatively low risk is due to the fact that there is a high probability of kicking out," said Hampson. "If the product kicks out, you get your capital back too. Therefore there is less risk to capital."

Not only is the kick-out highly probable, she said, but the chances for the call to occur on year one are also high, which also lessens risk.

As the expected duration is shorter, the immediate effect is to reduce credit risk as well, she noted.

"If you don't kick out after one year, it means your index has declined. You're therefore less likely to get a call after that because the index would have to grow - and not just stay the same - in order to offset those losses," she said.

"Compared to a three-year acceleration growth product, your riskmap here stands to be lower because it's only if you get to the end of the term that you get the risk."

High chances of gains

Because the premium rate on an annualized basis declines over time, the probabilities of earning the maximum call rate of 13.5% to 15.75% are the highest. Future Value Consultants, in a chart that displays probabilities of returns across different return buckets, found that the product offers a 73% probability of generating a 10% to 15% return.

"This is your payoff if you kick out early, and that's where you're the most likely to see the call triggered," Hampson said.

Probabilities of incurring losses are lower than a standard accelerated growth product because the occurrence of a call is also a factor that protects principal, she noted.

Good return score

The high probability of an early return of principal with an attractive call premium gives those notes a good return score of 6.22.

The return score is Future Value Consultants 'indicator, on a scale of zero to 10, of the risk-adjusted return of the notes.

The average return rating for the last 100 products rated by the firm is less than 4 at the moment, Hampson said.

"You have a high return score because of the chances of a kickout and therefore a high annualized return given the risk," she said.

Risk and return

The structure of the product is not without risks, but those are passed on to investors in the form of better terms as the issuer offers attractive call premiums, Hampson said.

One such risk is the existence of a leverage factor on the downside. For every 1% that the index declines beyond the 30% buffer, investors will lose 1.4286%.

"The leverage factor is just to bring the minimum return down to zero. It means you could lose 100% of your principal," Hampson said.

"But the reverse of the coin, I would assume, is that you get a higher kick-out rate compared to a deal with a buffer and just one for one. At least you would expect higher rates, otherwise you could always buy the equivalent product with no leverage on the downside."

An additional risk factor is the implied volatility of the underlying index. The implied volatility, which is used for the pricing of options, is approximately 29% for the Russell 2000 index compared to 22% for the S&P 500, according to Hampson.

"The higher implied should give you better terms," she said.

"That's because when volatility is high, there's more downside risk, which will generate more premium for the issuer who sells that risk. When selling the put, the issuer gets more money to spend on the upside."

Future Value Consultants gave a 7.65 overall rating to the product.

The overall score, on a scale of zero to 10, is the firm's opinion on the quality of a deal, taking into account costs, structure and risk/return profile.

"These notes score well compared to the rest of the current market," said Hampson.

The exact terms of the notes (Cusip 38143UPX3) will be set at pricing.

Goldman, Sachs & Co. is the underwriter.

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