Goldman's $169.52 million relative performance notes tied to sectors, S&P make bet on growth

By Emma Trincal

New York, Feb. 20 - Goldman Sachs Group, Inc.'s $169.52 million issue of 0% relative performance notes due March 4, 2015 linked to the performance of the S&P 500 index and a basket of three S&P sector indexes was a popular trade for its bullish bet on the economy, sources said. The structure was also seen as noteworthy.

The basket consists of the Select Sector Technology index, the Select Sector Financials index and the Select Sector Industrials index, according to the 424B2 filing with the Securities and Exchange Commission regarding the Goldman Sachs transaction, which priced last week.

The sector average return will be the average of the returns of the three sector indexes.

The payout at maturity will be par plus 108% of the upside return, if any, of the basket plus one-to-one exposure to the downside return, if any, of the S&P 500. If the upside return is not enough to offset the downside return, this payout will be less than par.

The deal comes on the heels of an almost identical offering priced a week before, Credit Suisse AG, London Branch's $225.9 million of 0% return notes due Feb. 25, 2015. It had the same underlying and terms except a higher participation rate of 109%.

Both of those large offerings - the Credit Suisse deal is the biggest issue so far this year - used JPMorgan as the placement agent.

In both deals, if both the sector average return and the S&P 500 are positive, investors only get the upside exposure to the basket but not to the S&P 500.

If the sector average return and the S&P 500 performance are both negative, investors will only be exposed to the S&P 500 decline.

Investors do not get exposure to the positive return of the S&P 500 nor do they get exposure to the basket return on the downside. As a result, investors will only get par at maturity if the basket return ends up negative and the S&P 500 positive.

'Silk top with leather pants'

A market participant noted the exotic nature of the structure.

"I've always thought structured products should have mismatched outfits, like wearing a silk top with leather pants. Whatever works, right?" he said.

"So we're seeing these Credit Suisse and Goldman Sachs issues placed by JP where the 'top' is Select Sector indices and the 'bottom' is S&P 500.

"And we see the Barclays Nikkei note where the 'top' is 'Asian' and the 'bottom' is 'European.'"

He was referring to Barclays Bank plc's 0% buffered return enhanced notes due Feb. 26, 2018 linked to the Nikkei 225 index, set to price Friday.

In this separate structure, Barclays offers leverage on the upside based on an average return, hence the term "Asian," which means in options jargon a payoff based on an average of different prices at different times. On the downside, however, investors are exposed to a point-to-point payout with a buffer. In options terminology, a European contract is one that's exercised at the expiration date, the equivalent of a maturity or near-maturity observation date for a note.

"You have a Euro-Asian option because it's averaged over five days and it's at the end," said Jim Delaney, head trader at Market Strategies Management, about the Goldman Sachs deal.

The final level of each index will be the average of its closing levels on the five trading days ending Feb. 27, 2015, according to Goldman Sachs' prospectus.

Dispersion trade

Delaney explained that the structure employed in Goldman's relative performance deal is reminiscent of a dispersion trade in options.

"You buy the volatility of the index, and you sell the volatility of individual components. In most cases the individual components tend to have a higher volatility than the index, so you're making a volatility play," he said.

"This note is a variation on that theme. You get the downside of the index. Because the volatility of the index is supposed to be lower than that of the individual components, even if the index's performance is negative it's not going to be as negative as it would be for the Select Sectors.

"The index tendency is to move less than each individual component. So you could reason that if you had to have exposure to the downside, you would want the exposure in the index itself rather than being exposed to the decline of the individual components."

He offered an example: the Select Sector Financials could be down 30% to 40% in one year, while the S&P 500 might only be down 20%.

"By the same token, the issuer is giving you on the upside exposure to what is likely to move more than the index," he said.

"You're getting the positive return of these three components plus the leverage.

"It's interesting to note that this deal has some of the elements of a dispersion trade."

Bullish bet on growth

For Matt Medeiros, president and chief executive of the Institute for Wealth Management, the main reason behind the success of the deal is that it enables investors to make a bullish bet on economic growth.

"Typically, the sectors that comprise the basket do well in an improving economy, when you are in the growth cycle," Medeiros said.

"Obviously, this is a very large size deal. It appears to be for a specific initiative.

"I like the short term of the notes when it comes to these sectors. The sectors they picked indicate that whoever bought the notes expects the economy to do well in 2014.

"It's a bullish bet on economic growth."

Last year, the market was still anticipating economic growth, which explains why the S&P 500 performed so well, he said.

"But as the economy matures, you're better off making sector bets.

"When growth picks up, companies refinance or finance purchases of new technologies.

"The S&P last year would have outperformed those sectors. Going forward, these sectors will outperform the S&P.

"The success of this offering was certainly based on this simple play on outperforming sectors.

"And as I look at those three sectors myself - financials, industrials and technology - I can see some advantage in this type of trade," he said.

Three outperformers

Delaney agreed.

"If you break it down, if you believe that industrials, financials and technology will outperform the market, you would want to buy these notes," Delaney said.

"I can see many reasons why this would be a good bet one year out."

Looking at technology, he said that the fact that Microsoft will stop supporting Windows XP in 2014 should have "ripple effects" on the entire technology sector.

"It's going to force people to go out and buy new hardware and software. So far, people have been postponing these purchases, but now they will have to upgrade. This will be very positive for the sector," he said.

Delaney also had a bullish take on financials.

"Everybody is getting used to the new regulations. New rules have been defined, and now they just need to be implemented.

"A good deal of the litigation is behind us. Most of the big fines have been paid already, so it should help earnings.

"In addition, consumer credit is expanding, the housing recovery continues. We're seeing more housing loans and more credit card debt. These are the ways banks make money."

Talking about industrials, Delaney said that most of the industrial stocks in the S&P 500 are multinational corporations.

"You're talking Caterpillar, John Deere, Dow Chemicals. All these are big, big firms that do their business on a global basis," he said.

"With the U.S. consumer improving as evidenced by their increasing debt load and the recovery in Europe gaining traction, global growth should continue to increase in 2014 and we should see more demand for industrial products.

"I can see a very reasonable bullish case for each one of these sectors. I can see them outperforming the S&P in 2014.

"In addition, they're giving you some leverage on the upside. For every dollar I'm making on the basket, I'm getting an additional eight cents."

Popular strategy

The nearly $170 million size of the deal, which comes shortly after a $226 million offering sold by the same agent, is not surprising, said Delaney.

The $226 million Credit Suisse deal priced on Feb. 7, followed by the Goldman Sachs offering on Feb. 14.

"The issuance was the size it was because those sectorial picks make sense," Delaney said.

"You've just seen two pretty big deals. If you add those two together, you get nearly $400 million.

"If demand is not there, you can't issue the paper. The fact that they were able to repeat the deal and get that size with a bit less leverage shows that demand is there."

Goldman Sachs & Co. is the underwriter with J.P. Morgan Securities LLC as agent.

The notes (Cusip: 38147QNP7) carried a 1.1% fee.

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