Goldman's $6.34 million trigger notes tied to S&P 500 enhance return in early sell-off scenario

By Emma Trincal

New York, Jan. 24 - Goldman Sachs Group, Inc.'s $6.34 million 0% trigger leveraged notes due Feb. 5, 2014 linked to the S&P 500 index have an innovative feature enabling investors to increase their potential upside participation if the equity benchmark falls below a certain level at the early stage of the deal, sources said.

The structure is designed for bullish investors who anticipate some volatility in the first three months of the deal amid the Congressional debate around the looming spending cuts and the debt ceiling among other headwinds such as earnings season, they noted.

The payout at maturity will be par plus 2 to 3.1 times any index gain, depending on whether a trigger event has occurred, up to a cap of 14% to 21.7%, according to a 424B2 filing with the Securities and Exchange Commission.

If the lowest closing level of the index during the observation period, from pricing through April 18, is above 95% of the initial index level, the upside participation rate will be 2 times up to the 14% maximum return. Otherwise, the upside participation rate will be 3.1 times and the cap will be 21.7%.

Investors will be exposed to any losses.

Exotic option

"This is a down-and-in call. I've seen some of these before but mostly lookbacks," a structurer said.

In a down-and-out option, the option becomes activated when the price breaches the barrier, which means in this case when the index drops below the 95 trigger, he explained.

"In addition to outperforming the index, the call activates only if the price goes below the strike. It's a window barrier in the first 90 days of this product," he said.

"The strike is set at 5% below the spot. If during that time the trigger is hit, the call comes into life, which allows additional participation to the upside."

The advantage of a down-and-in call is the cost-efficiency, he said. The premium is cheaper than with a plain-vanilla option, which helps reduce the cost of buying the call.

"This works for an investor who is bullish but worries about volatility picking up short-term," he said.

"We're in the midst of a reporting season, and some major companies may disappoint by reporting below-expectation earnings. If you're bullish on a one-year term but believe that a 5% correction may occur prior to that because the market may have been a bit overbought, then this type of product could make sense."

Two caps

Steve Doucette, financial adviser at Proctor Financial, noted the absence of any downside protection, but he downplayed the risk as he considered the notes as enhanced growth products designed to be used as equity replacements in the portfolio. For the very bullish investor, the downside risk is secondary compared to the risk of missing out on the upside, he said.

"I wouldn't be concerned with the lack of downside protection. This is a bullish note, and you're not taking more downside risk than you would if you were just long the index," he said.

Doucette noticed the difference between the two caps, one at 14% and the other at nearly 22%.

"It's a very simple note with one-time downside and leverage on the upside. You have to be bullish, but the question is whether the cap is enough if you're really bullish and will you have this 5% drop that kicks in early.

"For sure, nobody is ever going to complain about 14% or 22% in a year."

But the trade involved some element of timing of the market, he said.

"You need an initial sell-off and a gain at the end, but not too much of a gain. The only downside to this note is if the market really picks up in momentum a year from now and trades above the cap," he said.

Worth the risk

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he did not see any upside risk.

"You would have to be a perma bull not to be happy with a 22% annual return. I haven't talked to too many investors who anticipate this type of one-year return," Medeiros said.

"We're interested in the S&P, and we do believe it will have a positive year. But it will be choppy getting there. I don't know if we will have a 5% drop in value within the next 90 days or not. But even if we don't, I wouldn't mind a high single-digit, low double-digit return for one year. Worst-case scenario, the cap of 14% doesn't bother me," he added.

"The opportunity to enhance the upside participation if there's an initial pullback in the next 90 days adds value to this note. It's worth taking the risk of having no downside protection."

The scenario of an early sell-off is made more plausible with current headwinds, he said.

"We're halfway through the earnings season; we do anticipate earnings slowing down a bit," he said.

"A 5% pullback initially is possible. We have a number of things that could trigger it, from new concerns in Europe to the political conundrum in the U.S."

Medeiros said that he liked the payout. Even in the absence of a trigger event in the first 90 days, an investor could achieve a 14% annualized rate of return with only a 7% increase in the S&P 500.

"It's a very interesting trade," he said.

"It's based on what you would expect from the market. I like the fact that no matter what, at 14%, I know that I'm going to get a cap that's within the range of my expectation.

"An early market sell-off, which is not unlikely, would only make a good thing better."

The notes (Cusip: 38141GMH4) priced on Jan. 18.

Goldman Sachs & Co. was the underwriter, with JPMorgan as placement agent. The fee was 1.1%.

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