Goldman Sachs' knock-out notes tied to Apple offer hedge, attractive upside and high risk

By Emma Trincal

New York, June 22 - Goldman Sachs Group, Inc.'s 13-month 0% equity-linked notes tied to Apple Inc. shares, are designed for investors who seek a positive return if the stock price goes up or down within a range, said Gurdeep Ubhi, structured products analyst at Future Value Consultants.

"Investors in this product don't have a strong market conviction on Apple; they're not making a directional bet," said Gurdeep Ubhi, structured products analyst at Future Value Consultants.

"They're likely to be bullish but at the same time, they expect some volatility around the name. They lack conviction on the direction of the price, and for that reason they want to hedge their bet with the absolute return."

A knock-out event occurs if Apple stock ever closes below the 75% trigger level during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

If the stock finishes above its initial price, regardless of whether a knock-out event occurs, the payout at maturity will be par plus 1.5 times the gain, up to a maximum return of 30% to 34%. The exact cap will be set at pricing.

If the stock falls but a knock-out event never occurs, the payout will be par plus the absolute return.

Otherwise, investors will be exposed to any losses.

'Straddles' strategy

Those product types, also called absolute return or dual directional notes are staging a come-back, Ubhi said. His firm categorizes them as "straddles" in reference to the option strategy they mimic.

"Straddles disappeared for a while but they've been more popular over the last 18 months," he said.

His firm, he said, has been rating four such products in April, followed by 10 in May and has already reviewed half a dozen so far this month.

"They appeal to someone who isn't clear about the direction of a stock or an index.

"In volatile times, things can go up and down and so with these notes, you can bet against both directions," he said.

Ubhi observed that the note has a knock-out event that can be triggered any day during the term, which represents a so-called American-type of option, unlike other straddles, which are based on a final observation, using a European-type of barrier.

With the American barrier exemplified with this product, the knock-out event is more likely to occur, which is an additional risk factor, he said.

For the moment, Future Value Consultants is only rating straddles with an American barrier, such as this one, he noted.

The notes' ratings are compared to two categories: all recently rated products (average of all products) and other absolute return notes (average of the same product type).

The product shows higher risk levels than both all products and similar types, according to Future Value Consultants' scoreboard.

High risk

The riskmap is the score on a scale of zero to 10 used by Future Value Consultants to grade the risk associated with a product. It represents the sum of two risk components - market risk and credit risk.

The higher the riskmap, the higher the risk of the product.

With a 4.88 riskmap, the notes present a greater level of risk than the average of all products at a 4.20 riskmap.

The all-products-type riskmap is largely influenced by the risk profile of reverse convertibles, which overpopulate the category, explained Ubhi.

"At first this absolute return product and the reverse convertibles appear to have similar risk characteristics," he said.

"Both are tied to single-stocks and they're constructed around an American barrier.

"There's a difference though: with a reverse convertible you get the coupon regardless. It helps offset some of the losses.

"Since the riskmap is a score that measures the chance of losing principal, you're going to have a higher riskmap with this product than with a lot of reverse convertibles due to that," he said.

Another factor increases the likelihood of the knock-out event to happen: the size of the protection itself. The 12-month reverse convertible notes recently rated by Future Value Consultants have an average barrier of 72%, said Ubhi. The lower average barrier increases the layer of protection to 28% from 25%.

"A 25% barrier with a stock is reachable especially when it can happen any day," he said.

"Assuming the barrier is breached and the stock goes back up, it's unlikely that you'll get back up with a gain. It may reduce the losses but the odds of a positive return at maturity are slim."

The Goldman Sachs note also involves a higher riskmap when compared to similar straddles based on the same "any day" barrier type, as those show an average riskmap of 4.22.

"Some straddles are linked to the S&P 500. This being tied to a stock, a more volatile underlying, the odds of breaching the barrier are greater," said Ubhi.

Those risk factors which contribute to elevate the riskmap - the American barrier; the use of a single stock; and the size of the conditional protection - are exactly the same which push up the market riskmap, he said. At 4, the market riskmap of this product is superior to that of all products and all similar products, respectively scoring 3.50 and 3.44.

The 0.89 credit riskmap of 0.89 on the other hand has more to do with the 13-month duration, which is greater than most products, which also have a lower credit riskmap of 0.71.

Just because the risk is high does not mean that the notes lack an attractive risk return profile, said Ubhi.

Return potential

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions - neutral assumption, high and low growth environments, 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.

The 7.63 return score exceeds 6.49, the score for all products. It is also more attractive than the return score for similar structures, which is 6.98.

"The high return score is based off the best scenario, which is high growth in this case," Ubhi said.

"This scenario influences the return score because with high growth, you're very likely to get a good return given the terms of the product."

Part of it is due to the wide range of possible returns covering any decline up to 25% and any stock price appreciation up to the 34% cap. Another reason is the appeal of the upside potential, he explained.

Not really bearish

A straddle is an options strategy in which the investor has a position in both a call and put at the same strike price.

With this product, Ubhi said, the strike or maximum return on the downside is 25%, while it is between 30% and 34% on the upside.

"It's basically the same. Getting those two strikes to be the same or nearly symmetrical is a marketing factor. People like the idea that you can get equal amounts of return whether the stock goes up or down," he said.

However, the notes in essence target bullish investors.

"Ideally, you want to hit the upside cap and that's why the best scenario in our scoring process is high growth.

"While it's good to be able to make a return when the stock goes down, you want to stay away from that. The closer you get to the barrier, the more chances you have to breach it.

"The worse for investors is to hit this barrier because at that point, they lose both the protection and the absolute return potential," he said.

Under the high growth assumption, Future Value Consultants estimates in its probability chart that investors in the notes have a 57.6% chance of earning an annualized return of 15% and above.

"You have a very good return score simply because the issuer gives investors a good compensation for the risks they incur," Ubhi said.

"The 34% is a big cap. It gives investors a good chance to maximize returns especially because it's leveraged. That leverage element definitely helps the product. It makes it easier for the investor to hit the cap."

Price, overall

Future Value measures with its price score on a scale of zero to 10 the market value of the underlying components of the product. Calculated as a percentage of the initial investment, the score gives an estimate of the fees taken per annum.

The higher the score, the lower the fees and the greater value offered to the investor.

The notes have a 9.38 price score compared to 7.68 for similar products.

"It's a high price score because the issuer spent a decent amount on the options. They're offering a high cap, some gearing, downside protection and the absolute return potential on the downside," he said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

The overall score for this product is 8.51 versus 7.33 for similar products and 6.73 for all products.

"Despite the high risk profile, the upside potential is enticing," said Ubhi.

Goldman Sachs & Co. is the underwriter.

The Cusip is 38143UZ53.

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