Goldman's buffered notes with 16.25%-18% cap linked to MSCI EAFE are aimed at cautious bulls

By Emma Trincal

New York, Jan. 27 - Goldman Sachs Group, Inc.'s 0% buffered index-linked notes linked to the MSCI EAFE index target investors seeking to invest in international equity and who are willing to take a limited upside in exchange for more safety than a direct investment in the index, said Suzi Hampson, structured products analyst at Future Value Consultants.

The 13- to 15-month notes are not leveraged on the upside, and they are capped at 16.25% to 18%. Both the maturity and the cap will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors in this product are interested in the protection offered by the 20% buffer, she said.

"The upside is capped. There is a downside protection. It's quite symmetrical. The trade-off is that you're getting a little bit of protection but you're capping your gains. That's the sacrifice you have to make," she said.

"This would appeal to a slightly more cautious investor compared to someone buying the index directly. Investors in this product are not conservative really in the sense that your capital is still at risk and you can lose 100% of it. But they are more cautious. It's a more prudent way to express a mildly bullish view on this benchmark," she added.

The MSCI EAFE index is a benchmark used to measure international equity performance. It tracks the equity performance in developed markets outside of North America: Europe, Australasia and the Far East.

"It's a well-known index. It's not complicated," she said.

"The notes have a slightly lower return score than other similar products but much less risk. For someone who wants to invest in this index, it would be appealing."

The cap, on a compounded and annualized basis, would range between 14.96% and 16.56%.

"If you don't think the index is going to grow by more than that and are interested in getting exposure to these types of markets but with some caution, this type of product would be appealing," she said.

The product received good scores compared to its peers.

Other comparable products in the same category are defined as notes with unleveraged upside with a variety of different maturities. Such products may or may not offer downside protection.

Compared to that group, the Goldman Sachs buffered notes are less risky and better priced, according to Future Value Consultants' ratings.

Riskmap

The riskmap, a Future Value Consultants rating, measures the risk associated with a product on a scale of zero to 10.

Products of the same type have a 4.12 average riskmap. This one has a much lower score of 2.80.

"The usual buffer with growth products would be 10% or 15%, and this one has 20%, which is much bigger. That's one reason," she said.

"Some products are also longer term, which adds risk. In fact, the majority of the similar products are unusually one to two years, so we're on the shorter end of the range here."

The riskmap compares the average product underperformance (relative to cash) with the average underperformance of five sample assets of different volatility levels. The risk rating equates the risk of the products against the five hypothetical assets.

Another factor that may reduce risk is the volatility of the underlying index, Hampson said.

"You get some of those linked products tied to individual stocks. This one is tied to an index, and while slightly more volatile than the S&P 500, the volatility for the EAFE surprisingly is not that much higher," she said.

The implied volatility of the S&P 500 and the MSCI EAFE is 21% and 23%, respectively.

The riskmap is the sum of two risk components: market risk and credit risk.

For this product, most of the risk is concentrated in market risk. It has a market riskmap of 2.80 versus 4.12 for comparable structures.

"It's typically the case with growth products. As soon as you have capital at risk, most of the risk is due to market risk," she said.

Potential loss of 100%

In addition to that, the downside protection is above average not only because of the buffer amount but also because similar types of products offer protection features that may not be as efficient as a buffer, such as a barrier. Some have no downside protection at all.

One less attractive aspect of the product is that investors lose 1.25% for every 1% that the index declines beyond 20%, according to the prospectus.

For some investors, this feature is seen as a "downside gearing" and has little appeal, noted Hampson.

But she said the negative aspect of this factor, that it accelerates the loss once the index's decline exceeds the buffer level, is often exaggerated.

"It does not really add risk. What it does is to bring your potential amount of loss to 100% instead of 80%. But it happens gradually," she said.

"You're still going to outperform the index, even with this 1.25 factor. Say that your index falls by 50%. If you're long the index, you lose 50%. With this, you lose 30 times 1.25, which is a 37.5% loss. You're obviously ahead of the index.

"Some people call this downside leverage, but that's not really the case because your strike is not at 100, it's at 80. You still have a 20% buffer.

"Geared leverage or not, when you have a buffer, you're never going to underperform the index on the downside because you get that 20% protection on the first losses."

The credit riskmap at 0.96 is slightly higher than that of similar products at 0.74.

"It's not a huge difference, but usually when the credit risk is higher, it tends to be because the product is longer in duration. It's not the case here. So I think we may attribute this slight difference to the creditworthiness of the issuer," she said.

Goldman Sachs credit default swap spreads were 270 basis points, which is wider than other banks such as Barclays at 180 bps and Deutsche Bank at 170 bps, she said.

Return score

Future Value Consultants measures the risk-adjusted return with its return score, which is calculated under reasonable and consistent forward-looking assumptions.

The rating is measured on a scale of zero to 10. A high return score means that the return compared to the risk is high.

The notes have a 7.01 return score versus an average of 7.33 for products of the same structure type.

"It's a little bit less than comparable products, but it's not really bad," she said.

The notes' return score is higher than 6.40, which is the average for all products recently rated by Future Value Consultants.

"Growth products in general tend to have a higher return score average than all products, because in all products, you have a great deal of reverse convertibles that do not offer the best return scores," she said.

"You can still consider the return of this product a fair score."

The return score is derived from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

The performance is modeled based on a series of parameters, which include volatility, dividends and interest rates among others.

The probability table associated with this product shows that the odds of incurring a loss versus making a profit are 17% for losses and 83% for gains. There is a 37% chance of generating a small return of zero to 5% per annum, and the probability of losing more than 5% of principal is 11%.

Price, overall

With its price score, Future Value Consultants measures on a scale of zero to 10 the real value to the investor after deducting on an annual basis the costs the issuer charges in fees and commissions.

The more the issuer spends on the options, the more it provides value to the investor.

The notes received an 8.10 price score, above the 7.60 average rating for the same product type.

"The issuer has spent more on the options here, so you're getting a higher value on your money," she said.

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

Because the price score is above the average for the same product type while the return score is slightly below, the 7.55 overall score for this product is just in line with its peers, which have an average overall score of 7.47.

"It's pretty much the same. The likelihood of getting a product that scores well on all levels is low," she said.

"Here the price score is higher. The return score is lower. They cancel each other out, and you have something close to similar products."

Goldman Sachs & Co. is the underwriter.

The exact deal terms will be set at pricing.

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