Goldman Sachs' notes with 20% buffer tied to S&P 500 give bulls slight leverage, no cap

By Emma Trincal

New York, Aug. 10 - Goldman Sachs Group, Inc.'s 0% leveraged buffered index-linked notes tied to the S&P 500 index target investors seeking equity exposure with some downside protection and no limit on the upside, said Susi Hampson, structured products analyst at Future Value Consultants. The leverage factor, however, is mild. Compared to an exchange-traded fund, investors do not receive dividends and are subject to credit risk.

"If you don't mind taking on some credit risk, this is an alternative to an ETF," said Hampson.

Filling the blanks

The maturity date is expected to be between 36 and 40 months after the pricing date, according to a 424B2 filing with the Securities and Exchange Commission. The payout at maturity will be par plus 1.05 to 1.2 times any index gain.

Investors will receive par if the index falls by up to 20% and will lose 1% for each 1% decline beyond 20%.

"It's a replacement of U.S. equity for a bullish investor over the medium-term. The investor has a profile similar to someone who would buy a tracker or ETF," she said.

Hampson stressed the difficulty for analysts to rate notes with no set terms. This product for instance, she said, could have a maturity of three years, three-years and three months or anything in between.

The leverage factor also varies from 1.05 - which is "almost nothing" - to 1.2 times, "a more interesting gearing," she said.

"These are wide ranges and we need to pick a term in order to rate those notes," she said.

"We've made generous assumptions, choosing three years for the tenor and picking a 1.16 gearing, which is at 75% within the factor range. It's the shortest maturity and a high participation rate. But those undefined terms make the product difficult to rate. They haven't told you what they are offering you. You have two variables and for each, a wide range to play with. To get a realistic score, we'll have to wait for the pricing date," she said.

The note turned out to have good ratings, but Hampson said that it was hard to say if it was the result of the notes themselves or the "generous" hypothetical terms chosen.

"If this note had received terrible scores with our assumptions, we would know the product had little appeal. Here we won't know until we re-price it on pricing day," she said.

Equity replacement

One of the attractive features of the notes is the uncapped return, she said.

"You can get rid of the cap here because they only offer a slight gearing. Also, it's a three-year term. Most leveraged buffered are between one-year and 18 month. With a three year, you can definitely offer uncapped return," she said.

Investors in the notes would have a very similar profile to that of equity investors buying the equity in an ETF format, she said.

"These notes directly compete with an ETF," she said.

"It's for investors who want U.S. equity exposure for three years. It offers slightly geared participation which compensates somehow for the loss of dividends. On the downside, it offers you more protection but you are subject to credit risk. It's unclear whether the gearing fully compensates you for the lack of dividend. For one thing, we don't know the exact leverage factor. We also know that dividends get paid regardless of the performance.

But when you have 100% participation only, you can always argue that the dividend-paying investment will give you more by definition. It's not so clear-cut here," she said.

Less risk

Because of the 20% buffer, the notes offer good risk scores compared to those of "similar products" and "all products" listed in the report.

The similar products group includes all leveraged notes whether capped or uncapped, with or without downside protection. The all products category represents all recently scored notes with a heavy proportion of reverse convertibles.

The risk associated with a product is measured on a scale of zero to 10 by the riskmap, which is the sum of two risk components - market risk and credit risk.

The notes scored 3.60 on the riskmap scale compared to 4.13 for similar structures.

The market riskmap was also better at 2.11 compared to 3.14.

Both the riskmap and its market risk component were kept low due to the downside protection.

"It's substantially less and that's mostly because the 20% buffer is a lot for a buffer. Usually, you have buffers of 10% or less. You also have barriers providing less protection than a buffer and you also have notes with no protection at all. Finally, other leveraged products may be linked to risky underlying. The S&P 500 is certainly not the most volatile," she said.

The credit riskmap on the other hand, at 1.50 exceeded the average score of similar notes set at 1.

"This could be a combination of the issuer and the tenor," she said.

A longer maturity always increases the credit risk.

Goldman Sachs' credit default swap spreads are at 250 basis points, wider than Barclays' 200 bps but tighter than Morgan Stanley at 330 bps.

Return, price

Future Value gives its opinion of the risk-adjusted return with its return score. The score is calculated from five key assumptions - neutral assumption, high and low growth environments, and high and low volatility environments. The research firm calculates a risk-adjusted average return for each assumption. The return score is the best of these five returns.

The notes have an 8.13 return score compared to 7.28 for the average score of similar products.

"It's a good return score and we have several factors at play," said Hampson.

"You take the leverage plus the uncapped return and a three year maturity. In addition, the return score is calculated from the best performing scenario, which is high-growth in this case. Once you put together the high-growth assumption, no cap, some sort of leverage, you are going to have a good return score," she said.

The score was also better than 6.53, the average return score for all products.

It was due to the high population of reverse convertibles in the all-products category, she explained.

"Reverse convertibles by definition are capped at the coupon level. The cap really hurts the return of those products. Also reverse convertibles are usually risky with high chances of losing capital," she said.

Future Value Consultants with its price score measures on a scale of zero to 10 the market value of the underlying components of the product.

At 8.08, the product's price score is well above its peers set at 7.25. It is also superior to the average price score for all products of 7.

"It's the most difficult rate to produce because we're dealing with these two variables: maturity and leverage. With the price score, we try to value the assets based on the product terms. But we don't really have set product terms here. I'm not really sure we can read much into it," she said.

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

The notes have an 8.11 overall score versus 7.36 for similar products.

"Again, this is subject to what the exact terms of the deal will be at pricing," she said.

Goldman Sachs & Co. is the underwriter.

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