Goldman's leveraged notes with no cap tied to S&P 500: duration, credit risk are main concerns

By Emma Trincal

New York, April 18 - Goldman Sachs Group, Inc.'s 0% leveraged buffered index-linked notes tied to the S&P 500 index offer an appealing upside potential, but the notes' duration is seen as the drawback for some market participants.

The notes will mature 36 to 42 months after issue, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 1.2 times to 1.4 times any index gain. Investors will receive par if the index falls by up to 15% and will lose 1.1765% for each 1% decline beyond 15%. The exact upside leverage factor will be set at pricing.

Vague tenor

For Clemens Kownatzki, an independent currency and options trader in Los Angeles, what may be problematic with the duration is that Goldman Sachs did not specify the exact maturity date in its prospectus.

The 36 to 42 month tenor, or three to three-and-a-half years, is not precise, he said.

The exact maturity date will be set at pricing.

"I really have a problem not knowing what the real maturity is," he said. "If the gap was just a few weeks. But a six-month window is huge.

"How do you evaluate the downside risk without even knowing the exact term? From a simple risk management perspective, I wouldn't even begin to look at it before knowing the timeframe."

That said, the notes offer an attractive potential return.

"The upside leverage is obviously good. Having no cap is always great," he said.

But the market risk remains too high, according to Kownatzki.

"A 15% buffer on a three-year is not that big, really," he said.

"And then you have this gearing on the downside. That too makes it more difficult to assess the risk," he added, referring to the leverage factor of 1.1765 times that applies to each point of index loss beyond the buffer level.

With a normal buffer, the most investors could lose would be 85%, but with this note, investors could lose their entire principal, the prospectus warned.

"I have serious concerns, especially with the downside gearing and the unknown maturity," he said.

Outperformer

Marc Gerstein, research consultant with Portfolio123, said that the product is likely to outperform the benchmark, which makes the investment attractive.

But a three-and-a-half-year duration raises the credit risk issue.

"From a market risk standpoint, it's a no-brainer," he said. "You're going to outperform the index on the upside.

"Sure, you're not getting dividends, but you can live with that. The leverage makes up for that and in addition, your upside is unlimited."

For the downside, Gerstein noted that the buffer gives investors an advantage over being long the S&P 500 index.

"Absolutely you can outperform the index," he said.

Assuming a 2008-type of market scenario, or the "worse possible market," he said that investors in the notes would still fare better than a long-only equity investor in the benchmark despite the downside leverage.

"Even if the market was down 40%, you would lose less than 30%. You may have this downside gearing, but you still have the 15% cushion. You're still outperforming the index," he said.

"You'd have to see the index go down to nearly zero to be at zero yourself, but if that's the case, we're now dealing with credit risk, not market risk. Chances are that Goldman Sachs would blow up."

Hedging Goldman Sachs

Because of the longer-than-usual duration, investors should be concerned about the issuer's creditworthiness first, according to Gerstein.

"The only risk you're having is entirely credit risk. And I wouldn't want to go unhedged on that," he said.

"Not to say that Goldman Sachs is going to blow up in three-and-a-half years. But it's not inconceivable. Other big broker-dealers have gone belly up before.

"Goldman is still a trading firm. They take risks. They've been smart so far. But who knows who will be working on the desk three years from now?

"This is a three-and-a-half-year paper. I'm going to assume that it's what it is since they don't give a maturity date. I'll take the longest term. Well, that type of duration with exposure to the credit risk has got to be hedged. It's part of the calculation.

"I would probably buy a very long-term out-of-the-money put on Goldman. I could buy a put directly on the S&P, but doing it on Goldman would probably be better in order to hedge the Goldman risk.

"The longest-dated put I see [on Goldman Sachs] is January 2014. I would use that, bearing in mind that I have to roll it over at some point to push it for 2015.

"Basically, the terms of this note are pretty good. There is no cap. I think they're leaving you enough room to hedge it properly."

Goldman Sachs & Co. is the underwriter.

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