Goldman Sachs' notes tied to the Dow offer capital protection, no cap for U.S. equity exposure

By Emma Trincal

New York, Aug. 24 - Goldman Sachs Group, Inc.'s 0% leveraged notes tied to the Dow Jones industrial average are designed for investors looking for safety without sacrificing their upside potential, said Suzi Hampson, structured products analyst at Future Value Consultants. The trade off, she said, is that no dividends are received, the duration is long term and the upside participation rate somewhat limited.

The product can be viewed as a less risky alternative to a tracker or direct investment in the equity benchmark with the potential to outperform it, she said, although it may not be the case if the index is up given the lack of dividends.

The notes are expected to mature six years after issue, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 1.1 to 1.2 times the index return. The exact participation rate will be determined at pricing.

Investors will receive par if the index falls.

Trade offs

"They had to make the product long-term in order to offer the uncapped return. When you have a leverage factor of 1.5 times or more, you get a cap," she said.

But the main reason for the six-year tenor is the low level of interest rates, she said.

"You purchase your option with the gap between the notional and the cost of the zero coupon bond. When rates are low, structuring a full principal protection note becomes expensive, which is why issuers have to extend durations.

"The issuer was able to finance the protection without a cap with the dividends. One necessary step though was to reduce the leverage as much as possible.

"With this note, the investor has given up the higher participation rate for a no cap.

"Given the full principal protection and the absence of a cap, you should in theory outperform the index except that you have to take into account that you're not getting the dividends."

The Dow Jones industrial index has a 2.5% dividend yield.

"It doesn't seem like a lot of growth, but you would have to generate that in order to break even," she said.

Hampson noted that investors by giving up dividends and liquidity for a full capital protection were making a choice based on their market risk aversion.

Comparing a direct investor in the benchmark with a note buyer, she said that: "Both are bullish on U.S. equities, but they are very different types of investors. An investor in the notes is willing to take the credit risk of Goldman Sachs for six years and to give up dividends for a capital protection that an ETF doesn't offer," she said.

Low risk

Future Value Consultants' ratings reflect the principal protection element of the product, starting with its low level of risk.

The research firm measures risk on a scale of zero to 10 with its riskmap. The higher the riskmap for a product, the greater its risk is. The riskmap is the sum of two risk components: market risk and credit risk.

The Goldman Sachs notes have a 2.86 riskmap in par with similar products, which would be all 100% principal-protected products. Compared to all products, which have a 4.11 average riskmap, the reading reflects an important difference in risk levels. Most of the moderate risk profile of the notes comes from market risk, reduced to a minimum of 0.71 compared with 3.35 for all products.

The all-products category comprises various structures recently rated by Future Value Consultants and is heavily populated by a sub-group of reverse convertibles, one of the riskiest types of products, she noted.

"The riskmap is very limited and there is hardly any market risk. The principal protection is of course the main factor, here," she said.

The credit risk is also marginal, she said, at 2.15 versus 2.39 for similar products.

High return score

The notes show a good risk return profile as evidenced by the return score, which measures on a scale of zero to 10 the risk-adjusted return of a product. The Future Value Consultants' 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.

Since there is no cap, the best market assumption for this product is high-growth, she said.

The return score is 8.46 versus 6.54 for the average of all products.

"The uncapped element is the major force behind this high return score," she said.

"Most products have a cap or the equivalent of a cap. For instance reverse convertibles offer a maximum income; the accelerated growth types of products usually have some sort of a cap whereas this product has no maximum return."

The high score also derives from the market assumption, which is always the best for a certain structure type, based on the firm's methodology.

"If you are bullish and invest in a high growth environment with no cap, you're going to do very well. A product that is uncapped in a high growth scenario will always score high on the return scale as well," she said.

When using the neutral assumption, which is a risk free growth scenario, the notes show a 95.2% probability to earn a gain of 0% to 10% per annum while the chances of making more than 10% a year are only 4.8%.

With the high growth scenario used for the rating, investors have a 71.4% probability of earning between 0% and 10% and the likelihood of a gain in excess of 10% per year has now increased to 28.6%.

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 9.39 price score compared to 8.83 for similar products.

"We look at the equivalent price per annum. Six years to spread the cost over, the price score will come up better," she 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 notes received an 8.92 overall score versus 8.49 for similar products and 6.78 for all products.

"This high overall is the result of a product that shows a very good risk reward profile and value," she said.

The Cusip is 38143U6M8.

Goldman Sachs & Co. will be the agent.

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