Goldman Sachs' six-year leveraged notes linked to S&P offer full protection, enticing upside

By Emma Trincal

New York, March 24 - Goldman Sachs Group, Inc.'s 0% leveraged notes due June 30, 2020 linked to the S&P 500 index offer an attractive risk-reward trade-off combining full downside protection with a minimum guaranteed return as well as upside leverage. In exchange, investors have to take the credit risk of the issuer for six years and accept a cap on their return, but one that was seen as reasonable.

The payout at maturity will be par plus 1.25 times any index gain, up to a maximum settlement amount of $1,600 for each $1,000 principal amount. If the index falls, the payout will be $1,105 per $1,000 principal amount of notes, according to a 424B2 filing with the Securities and Exchange Commission.

Protection plus leverage

"I kind of like it," said Carl Kunhardt, wealth Adviser at Quest Capital Management.

"If offers the principal protection, in this case the full protection. That's what I like to see in a structured note.

"The leverage is attractive because it's only on the upside.

"The 10.5% minimum return on the downside is not huge, but it's not very common to get more than par if the index declines. That's more than your typical principal protection.

"It's a nice mix. The fact that they're still able to give you leverage even though there's full downside protection is pretty unusual. Normally you get one or the other. For instance, you may get a buffer but with a little bit of downside leverage, which is not the case here."

Quarterly averaging

The payout is calculated based on the averaging of the index return.

The final index level with be the arithmetic average of the closing levels of the index on each of the averaging dates, expected to be the 25th of each March, June, September and December, beginning June 25, according to the prospectus.

Using the arithmetic average of several closing dates may in some cases lower the overall return, the prospectus warned in its risk section.

For instance, a sudden surge in the index performance toward maturity could easily be offset by a series of declines on other averaging dates.

"Sure, they may have been able to partly pay for that leverage with the quarterly averaging, which has its disadvantages. Chances are the averaging will give you less return than a point to point," Kunhardt said.

"But I don't mind because the principal protection is such a big piece of it. It's got to be paid somehow."

Bond or equity substitute

Kirk Chisholm, principal and wealth manager at NUA Advisors, said that assessing the notes is "challenging" because the structure is complex.

One way to analyze the notes is to compare them to a bond since investors are guaranteed the minimum 10.5% return over six years regardless of the performance of the index. But the product could also be analyzed as a pure equity play since it offers upside participation in the S&P 500 index. Chisholm ruled out the latter.

"I wouldn't compare this note with a direct investment in the S&P 500 index," he said.

"Trying to predict the return of the S&P over six years is a fool's errand.

"The notes offer a reasonable alternative to the index on the downside because you're getting the principal protection. But on the other hand, you're locked in for six years with credit risk exposure and your return is capped at 60% while the S&P 500 would have no limit on the upside.

"So I think it makes more sense to evaluate this note by comparing it to an investment that carries the same credit risk, and that would be a Goldman Sachs corporate bond."

Goldman Sachs paper

Chisholm said that the yield to maturity of a six-year Goldman Sachs corporate bond is 3.18%, which is nearly 20% over the six-year term.

In comparison, the notes offer a minimum return and a maximum return.

On the maximum end, investors in the notes could gain up to 60% in the six-year period, which, he said, is the equivalent of 8.15% compounded per annum.

On the lower end of the range, the noteholders would get 10.5% over the period, or 1.6% compounded per year.

Risk

"So with the bond, you're guaranteed to get an annual yield of 3.18%. With the notes, you know that you're going to earn at least a 1.6% annual return," he said.

"If you compare the risk of investing in the notes versus the bonds, you can eliminate credit risk. It's the same for the two. It's not a factor.

"Your risk when choosing the notes is going to be making 1.6% instead of 3.18% a year. You're basically incurring the risk of losing 1.58% per year."

Reward

"Now let's look at the maximum upside potential," he said.

"Obviously the reward of the notes is much higher. While the bond only gives you the coupon, the notes give you upside participation in the S&P 500 up to a 60% cap. That's an 8.15% compounded rate of return per annum versus 3.18%. You're talking about a 5% difference in potential upside.

"From my perspective, I'd rather take the risk of losing 1.58% a year for the reward of gaining an additional 5%. It's a no-brainer.

"If you're comfortable with Goldman Sachs credit quality, the note would be a preferable way to get credit exposure to this issuer. While the credit risk is the same as with the corporate paper, the notes give you a much better risk-reward."

Goldman Sachs & Co. is the underwriter.

The notes will price Tuesday and settle Friday.

The Cusip number is 38147QXK7.

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