Goldman Sachs' five-year notes linked to three baskets offer unusual 'best-of' structure

By Emma Trincal

New York, April 24 - Goldman Sachs Group, Inc. is readying an "unusual" offering, its 0% five-year basket-linked notes linked to the best performing of three baskets, that gives investors full principal protection in a relatively short term with no cap on the upside, sources said.

The main appeal of the notes, the sources noted, is that they offer exposure to the best performing of the three baskets. Each basket reflects a different allocation to four different asset classes.

A 'best-of'

Sources compared the structure to the better-known "worst-of," saying this deal is just the opposite.

In a so-called worst-of structure, notes are linked to multiple underliers and investors get the return of the worst-performing one.

"It's a best-of," said Andrew Valentine Pool, main trader at Regatta Research & Money Management, coining the term.

"I've not seen that before. That sounds nice compared to the typical worst-of."

Each basket will be made up of different weights of the currency component, the commodity component, the equity component and the Treasury bond component, according to a 424B2 filing with the Securities and Exchange Commission.

The currency component is an equally weighted basket comprised of the Brazilian real, the British pound, the euro and the Japanese yen, each measured relative to the dollar.

The commodity component is the S&P GSCI Excess Return index.

The equity component is an equally weighted basket comprised of the S&P 500 index, the Euro Stoxx 50 index, the Topix index and the iShares MSCI Emerging Markets index fund.

The Treasury bond component is the iShares Barclays 7-10 Year Treasury bond fund.

Three baskets

The prospectus summarized the main investment theme by saying that the notes are designed for investors who are bullish on all four asset classes but "uncertain as to which will have the greatest return." By getting exposure to the return of the best basket, investors get a chance to extract the best asset allocation.

The first basket, called basket A, is overweight bonds with a 55% weight in the Treasury component, 25% in equities, 15% in currencies and 5% in commodities.

Basket B is more balanced between stocks and bonds with an equal weight of 40% for each. Currencies and commodities represent a 10% weight each.

Basket C is the most focused on equity with a 55% allocation to this asset class. The Treasury bond component represents a 25% weight, commodities 15% and currencies 5%.

If the return of the best-performing basket is positive, the payout at maturity will be par plus that basket's return. If the return of the best-performing basket is zero or negative, the payout will be par.

The notes are capital guaranteed subject to Goldman Sachs' credit risk.

Short term

Pool said that it is "unusual" to see such notes with that type of duration and no cap on the upside.

"We've been looking for some principal protection, and we've seen a few with enhanced return," he said.

"But the problem is that most are six or seven years, and you always want to be a little bit shorter."

He said that he likes the diversification theme behind the deal.

"I like the idea of these three different baskets with the same asset classes but showing different allocations," he said.

"For instance, we like Europe long term. We think Europe is going through a bumpy ride at the moment but that five years from now the issues should be resolved. So we would make it in the sweet spot."

Compelling

Pool said that he would look into the investment further and might even consider it if Goldman Sachs makes the product "adviser-friendly."

A structurer said that the exposure to different asset class mixes with the return linked to the best makes the future offering very compelling.

"You have different kinds of exposure reflecting different types of investors' profiles. For instance, basket A with the largest bond allocation is for the more conservative type. Basket B with an equal mix of bonds and equities is for the more balanced type of portfolio. Basket C offers a strong concentration in equities. And the correlation is not 100% between those four global markets," he said.

"In all kinds of scenarios, you get the best of it. That's a good sale."

Exotic, hybrid

This structurer noticed the rather rare structure.

"This is something very exotic. It's multi-asset class. You have currencies, equities, bonds and commodities," he said.

"It's really cross continent, cross asset class. I haven't seen that.

"I've seen deals where they would offer the best of different currency baskets, but not across several asset classes. This one is more comprehensive. They probably sell it to their private banking."

Cheaper options

He added that he is intrigued by the pricing of the deal.

"They give you principal protection on a five-year as well as the best of the three baskets. No cap. It could mean several things," he said.

"First, Goldman has decent funding. But they also have cheaper options in there given that there is less equity."

Currency options, for instance, are "much cheaper" than options on equity, he noted, although the weight of currencies in the baskets is limited.

But options on Treasuries probably helped lower the cost of the overall structure because of their lower volatility.

In addition, the equities are based on indexes, not stocks or baskets of stocks. Furthermore, the equity component is diversified across three indexes and one fund.

Another factor behind the lower cost of the options, he said, is the low correlation between the asset classes.

"Look at basket A for instance, more heavily weighted in bonds. What happens if rates fall more and bonds rally? Equity prices could fall, offsetting the gains seen in Treasuries. This also makes the basket cheaper. The low correlation is paying out," he said.

This structurer predicted that these types of products may be in greater demand.

"It hasn't been done much to my knowledge, but if it becomes more popular among investors, more banks will replicate it for sure.

"But you need to price it, and it's not easy," he said.

Hedging

"This is something really hybrid, exotic. You can never truly hedge these truly hybrid baskets. If I'm the dealer, I have a residual risk that needs to be managed. You need a solid trading desk that can price the correlation," he explained.

"If the trading desk is comfortable managing that risk, they'll do it. Otherwise, they won't sell it."

A dealer with a bullish outlook on the dollar may be "more comfortable" hedging the risk, he suggested.

"If the dollar finishes down in five years, the note would generate a very low return. Chances are that at least three asset classes would go down in price in this bullish scenario," he said.

"If the dollar rallies in a flight to quality as a result of another financial panic, bonds will go up. But equities would fall a lot of course and so would commodities. Currencies in all cases will go down in price since the currency component is bearish on the dollar.

"The dollar could also appreciate if there is a stronger U.S. recovery. In this case, stocks should do well, but everything else, including bonds, would be likely to fall.

"So I think this is where the risk resides in these notes. You have principal protection, but you still want to earn something after five years. If the dollar goes up, the odds of generating an attractive return are against you."

Goldman Sachs & Co. is the underwriter.

The Cusip number is 38143U2S9.

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