Goldman Sachs’ 13-month leveraged notes tied to S&P 500 show good upside potential, some risk

By Emma Trincal

New York, May 20 – GS Finance Corp.’s 0% 13- to 15-month leveraged notes linked to the S&P 500 index are designed for short-term investors with a moderately bullish outlook on the market and some fair tolerance for risk, said Tim Vile, structured products analyst at Future Value Consultants.

The notes are guaranteed by Goldman Sachs Group, Inc.

The payout at maturity will be par plus triple any index gain, up to a 13.8% to 16.2% cap. Investors will be exposed to any losses, according to a 424B2 filing with the Securities and Exchange Commission.

Three times leverage

“This note offers a high level of participation. The cap is attractive. It doesn’t penalize investors too much. Add to that a short maturity. There is got to be a trade-off, and the trade-off is no downside protection,” Vile said.

The exact deal terms – duration and cap – will be set at pricing.

Vile picked the shorter end of the range for the tenor, or 13 months. He chose 15% for the hypothetical cap, which is at the mid-point of the range.

Moderately bullish

“The S&P doesn’t have to go up by more than 5% during the 13-month term. That’s not much. Obviously if you’re very bullish, you don’t need that kind of leverage,” he said.

The cap represents a 13.82% return per annum on a compounded basis.

“This is interesting because they’re still giving you a very high cap. In this market, nobody is going to complain about nearly 14% a year. The structure allows you to get there with only 5%. It doesn’t mean that it’s easy. If the market is flat or negative, you’re not getting there,” he said.

Trade-off

In order to combine the benefits of the short tenor, high participation rate and the use of a plain-vanilla benchmark, investors had to agree to be long the index on the downside.

“If you disagree with that bullish premise and are not comfortable with the one-to-one downside, this note is not the right product for you. You have to be slightly bullish and still tolerate risk,” he said.

“It’s a little bit of an all-or-nothing proposal. Either you get your leverage and hit your cap or you lose money.

“If you assume it’s easy for the S&P to be up 5% in 13 months, then this almost looks like a digital.”

Some risk

Future Value Consultants generates research reports that rate risk, return and value using a variety of proprietary scores in order to compare a product with others.

A product is compared with two categories: other products of the same type and all products. In this case, the product type is leverage return. That structure is defined as any note with an upside participation rate greater than 100%.

The risk associated with a structured note is measured by Future Value Consultants’ riskmap. The rating on a scale of zero to 10 measures the risk with 10 being the highest level of risk. The riskmap is obtained by adding its two sub-components: market risk and credit risk.

The notes have a 3.28 market riskmap, compared with an average score of 4.82 for the product type.

While there is no barrier or buffer in the structure, Vile said the relatively low volatility seen on the S&P 500 must have been the reason behind the lower market riskmap.

“I have to say that I was a little bit surprised. I was expecting a bit more market risk, although it’s not low risk,” he said.

“It’s probably a function of the volatility.

“We see more and more leveraged notes linked to riskier underlyings such as the Euro Stoxx for instance. So that must have made the difference.”

Credit

At 0.43, the credit riskmap on the other hand is slightly below the 0.46 average score for the product type.

That’s because the score is the result of two contradictory forces, he explained.

“It’s a very short-term note, and normally it should help. It should reduce the credit risk exposure. But we don’t see that in the score. That’s probably issuer’s credit-related. The issuer’s credit somehow offsets the benefit of the short duration,” he said.

The five-year credit default swap spreads for Goldman Sachs are 103 basis points, according to Markit. Morgan Stanley follows closely behind with 101 bps. But Bank of America’s spreads are tighter at 91 bps along with JPMorgan’s 70 bps.

By adding the two risk components, the model extracts a 3.71 riskmap versus an average of 5.28 for the product type. The gap narrows, however, when comparing the risk score with all products, as those show an average riskmap of 4.34.

Risk-adjusted return

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.

For this product, the optimal market scenario is bullish.

The return score is 7.12 versus an average of 6.84 for similar products and 6.48 for all products.

“It’s a very good score. The cap is really not bad. But you’re comparing this note with uncapped leveraged products. I think the cap, rather than the risk level, is what prevented the return score to climb much higher,” he said.

Value

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.

At 7.60 the price score is higher than the 6.95 average for the leverage return category.

“It’s excellent considering how short the term is,” he said.

Shorter products don’t score as well on the price scale as longer-dated ones. That’s because the fees are calculated on an annualized basis. As a result, there is less time for the cost to be spread over the length of the investment.

“This shows that the pricing is quite good. They spent a fair amount of money on the options, especially to provide three-time leverage on the upside. There is no downside protection, but you still get quite a high cap. There’s definitely a lot of value on the upside,” he said.

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 have a 7.36 overall score versus an average of 6.90 for the product type.

“This note offers a high potential for mildly bullish investors. There is no barrier or buffer. But for investors comfortable with the risk and not overly bullish, it looks like a pretty fair formula,” he said.

Goldman Sachs & Co. is the agent.

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