Goldman Sachs' leveraged notes tied to Lennar stock offer substitute for direct long position

By Emma Trincal

New York, May 9 - Goldman Sachs Group, Inc.'s 0% leveraged notes due May 28, 2015 linked to the common stock of Lennar Corp. are riskier than the average leveraged note, but they would constitute a good alternative for a bullish investor who would consider buying the stock itself, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par plus double any gain in the share price, up to a 29% cap. Investors will be exposed to any losses, according to a 424B2 filing with the Securities and Exchange Commission.

The final share price will be average of the closing prices of the stock on the five trading days ending May 22, 2015.

The notes are rated in the leveraged return category of products, according to Future Value Consultants, which rates structured notes based on risk, risk-reward return and value. The category is the widest one and includes leveraged products with all kinds of underlying assets, with or without downside protection.

However, the majority of leveraged notes tend to be linked to equity indexes or funds, noted Hampson.

Leverage on a stock

"This product is a little bit unusual as it's tied to a single stock rather than the S&P 500 or the Euro Stoxx. Usually stock-linked notes are reverse convertibles tied to volatile stocks, as they sell volatility. It's not that type of product here, although the underlying stock is quite volatile with a 30% implied," she said.

Since most leveraged notes are not based on single stocks, this product presents a higher risk profile than its peers.

"But if you compare this with a direct investment in the stock, the risk profile is about the same. Meanwhile, you are getting a different and quite attractive risk-return profile," she said.

In addition to the type of security used as the underlying and the stock's volatility, the structure itself adds to the riskiness of the notes by not delivering any kind of downside protection, she said.

"They include a little amount of averaging at the end with the five-day closing average. I'm not sure it makes a difference from a risk standpoint. It's not as if they were averaging out through the year as we sometimes see with principal-protected notes, which makes the option cheaper," she said.

"On the upside, the issuer sells a call to cap the return at 129%. It's a pretty high cap, especially over a one-year period. It's very competitive. You wouldn't get anything like that on the S&P, obviously."

Equity risk

For an equity investor who would consider taking a long position on the stock, the notes may be appealing, she said.

"The big plus is the double gearing," she noted.

"Your downside is the same if you remove dividends. And note that you're not giving up much here since this stock doesn't pay much in dividends and it's a one-year only."

Lennar has a dividend yield of 0.4%.

"So you really have the same downside risk but a limited upside with leverage. How limited? Getting nearly 30% in one year is relatively bullish. You would have to be really more bullish to worry about underperforming the stock. And again, you're only giving up a small amount of return in dividends," she said.

"You're getting double gearing, and your cost is the 29% cap. The credit risk you're getting exposed to doesn't carry a high price tag either. This issuer doesn't have terrible spreads, and it's a short-term duration."

The five-year credit default swap spreads for Goldman Sachs are 84 basis points, only slightly higher than other firms, with Bank of America at 69 bps, Citigroup at 72 bps and JPMorgan at 56 bps, according to Markit.

"All this makes the notes a viable alternative to a direct equity investment. You take on the same market risk, and your cap doesn't penalize you that much. For someone who is not a full-blown bull, the double gearing adds another benefit," she said.

"However, if you compare it with the average leveraged note, this note, according to our scores, comes up as relatively risky.

"If the investor wants growth and is aggressive enough to invest in a non-protected product, this product is an acceptable option. It's definitely not suitable, however, for the typical buyer of leveraged notes on indexes who wants risk mitigation."

While most stock deals fit into the autocallable or reverse convertible categories, only a few will be structured with leverage, she said.

"I'm not sure why. It could be that most leveraged notes satisfy a demand for the less risky benchmarks and for longer maturities. With a two- or three-year maturity, an issuer can still get you attractive terms on an index," she said.

"Maybe it's always been that way. People are short volatility on stocks using very short-term reverse convertibles while they prefer growth products on indices over a longer time.

"In this case, perhaps Goldman saw a particular demand for this stock. It may have been one of their bullish calls, and the product would be investor-driven."

Riskmap

Future Value Consultants measures the risk associated with a product with its riskmap on a scale of zero to 10 with 10 as the highest level of risk possible. The riskmap is the sum of two risk components: market risk and credit risk.

The market riskmap for the notes is 5.76, compared with an average of 2.61 for products of the same type, according to the report.

"Even if a stock investor would not find the risk associated with this product off-putting, it still is much more risky than the average leveraged note," she said.

"First, the underlying is not the S&P but an individual stock that's relatively volatile. Second, most of the similar structures offer a barrier or a buffer. We have none of it in this case."

In terms of credit risk, the notes show less risk than average. The 0.38 credit riskmap compares well with the 0.62 average score for products of the same type.

"The credit risk is not really a story. That's not the risky part of the product. The high riskmap is related to the market risk. It's the underlying, the lack of protection that contribute to this pretty massive market riskmap," she said.

Lower return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

At 6.99, the product's return score is below the average for the same product type, which is 7.74. However, it is in line with the 7.03 average of all recently rated products across all structures, the report showed.

"The return score is linked in part to the riskmap. As the score is high on the risk scale, we end up with a less-than-average return score," she said.

"To raise the return score, the structure would have had to deliver more in potential return. It's not really a bad return score, especially if you compare it to all products, where it's average. But definitely, to measure up with the average leveraged note, you would need more on the upside given the high amount of risk you're taking."

Good pricing

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The product has an 8.05 price score. This is well above its peers, whose average price score is 7.58, according to the report.

"It's high. The product is priced very competitively. It's encouraging. They're not charging excessive fees," she said.

"It could be due in part to the fact that this is not a very complicated product.

"Sometimes, less complex products are cheaper to put together. You have fewer components. It makes it easier to hedge.

"No doubt that this is pretty simple in terms of options. All you really have is a call spread, and the rest is a tracker."

Cap effect

Hampson noted that with these notes, the relationship between the price score and the return score was inverted.

"They do often move in line but not always. Normally, return score and price score are correlated. In this case they clearly moved the opposite way. It may be because the price score is based on the risk-free rate while we use for the return score the best of five scenarios, which would be bullish in this instance," she said.

"If you choose the bullish assumption and rate this note against other leveraged products, any uncapped deal is going to price much better than this one. In fact, uncapped products in the bullish scenario will price extremely well on the return scale. Because this particular product is capped, it may explain why the return score is lagging behind its peers. You only need the stock to be up by 14.5% for the year in order to hit your cap. The growth assumptions we make are in proportion to the volatility. Given how volatile the stock is, this level of return may be easily achievable and you may be hitting your cap a lot of times, which is obviously not as good as if you had an uncapped note."

Overall score

The overall score measures Future Value Consultants' general opinion on the quality of a deal. The score is the average of the price score and the return score.

The notes received a 7.52 overall score. In comparison, the average overall score for leveraged return notes is 7.66.

"You end up with an average overall score. But actually, depending on which area you want to look at, it's not average. The reason we include our four main statistics - price, return, credit risk and market risk - is because we want to be able to show the different pieces of a deal. This one can definitely be looked at from different angles," she said.

The notes (Cusip: 38147Q5V4) priced Friday and are expected to settle Wednesday.

Goldman Sachs & Co. is the underwriter with J.P. Morgan Securities LLC as placement agent.

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