Goldman Sachs' buffered leveraged notes linked to MSCI EAFE target more bullish investors

By Emma Trincal

New York, July 29 - Goldman Sachs Group, Inc.'s upcoming 0% leveraged buffered index-linked notes linked to the MSCI EAFE index are designed for bullish investors seeking exposure to developed countries, said Suzi Hampson, structured products analyst at Future Value Consultants.

The notes are expected to mature 24 to 27 months after issue, according to a 424B2 filing with the Securities and Exchange Commission. For her model and simulations, the analyst picked a two-year term.

The payout at maturity will be par plus 1.5 times any gain in the index, subject to a maximum return of 33% to 38.25%. The exact maximum return will be set at pricing.

Investors will receive par if the index falls by 10% or less and will lose 1.1111% for every 1% that it declines beyond 10%.

Goldman Sachs & Co. is the underwriter.

Higher cap for bulls

"We've seen higher gearing than 1.5 times. It's moderately leveraged, which is why your cap tends to be higher," said Hampson.

"This product would be for more bullish investors, people who see the index going up to 33% in two years.

"If you're not that bullish, you may want more leverage.

"And if you're even much more bullish than that, you should invest in the index directly."

The 1.111% factor

On the downside, there is a small leverage factor of 1.111 beyond a 10% decline. As a result, investors could lose 100% of principal. In the absence of leverage and given the same buffer, they could not lose more than 90%.

"I don't know if it makes a big difference in terms of how those products are sold," said Hampson.

But the important difference between the two types of buffers - with or without the accelerated loss - is that one contains and minimizes losses a little bit better than the other.

She offered the following example of a 20% decline with a 10% buffer. With a one-for-one decline after the buffer, investors would lose 10%. With this product, the loss would be 11.11%.

"So you lose slightly more. But it's not very significant. It becomes more significant as your loss amount increases," she said.

"Still, even with this type of buffer, you're better off than with a barrier."

A 90% barrier would offer a soft protection only for the first 10% decline. If the index was to decline 20%, investors' total loss would also be 20%.

"You lose the benefit of a buffer. It's worse," she said.

"Some people may be put off by a buffer with a downside gear. But really, it's much better than a barrier. It does put a brake on your losses."

Riskmap

The riskmap for this product, at 4.12, is much lower than the average riskmap of 5.54 for all structured products recently rated by Future Value Consultants.

Riskmap is a Future Value Consultants' rating that measures the risk associated with a product on a scale from zero to 10. The higher the riskmap, the higher the risk of the product.

The rating compares the average product underperformance (relative to cash) to the average underperformance of five sample assets of different volatility levels. The risk rating equates the risk of the products against the five hypothetical assets.

One factor behind the relatively low riskmap may be the implied volatility of the underlying index, which at 24% is "not vastly higher" than 21%, the implied volatility of the S&P 500, said Hampson.

The MSCI EAFE index is an international equity benchmark for developed countries excluding the United States and Canada. The United Kingdom, France, Germany and Japan represent nearly two-thirds of the index.

"There is a big difference between this product and all other types of products in terms of risk simply because what you have here is a less volatile underlying," said Hampson.

"The riskmap of the reverse convertible group is high in the 'all-products' category because reverse convertibles dominate as a group and also because they are linked to very volatile, risky, single stocks."

Riskmap is composed of a market riskmap and a credit riskmap.

For these notes, the market riskmap is in line with similar products but lower than the average of all products.

"It's the same reason: The average market riskmap for all products is pulled up by the extreme volatility of reverse convertibles," said Hampson.

However, the credit riskmap is higher than the average of all products.

"Again, you compare this product with a category dominated in numbers by reverse convertibles. Between this two-year note and a reverse convertible, which is often a three-month trade, the longer-dated security will represent more credit risk because the longer the term, the greater the risk of default," she said.

Risk/return trade-off

The notes have a return score of 7.55 on a scale of zero to 10. The score measures Future Value Consultants' opinion of the risk-adjusted return under reasonable and consistent forward-looking assumptions for underlying asset evolution.

The product has a return score in line with similar structures - which are all capital-at-risk products with leverage, whether they offer protection or not and whether the protection is established with a barrier or a buffer.

On the other hand, the return score is much better than 5.98, which is the average score for all products.

"The downside gear means that you could potentially lose more capital than with a regular buffer. But in exchange, you have a higher return [cap]," she said.

"As long as the risk is balanced to reflect more potential gains, you'll have a good risk/return profile."

40/60 probabilities

The return score derives from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

The performance is modeled based on a series of parameters that include volatility, dividends and interest rates among others.

With this product, investors have a 40% probability of losing capital and a 60% probability of making money.

There is a nearly 25% probability that investors will make more than 15%. This probability includes the probability of hitting the 33% cap, which is a 16.5% annualized rate of return.

Given the leverage factor, an investor needs about 11% in annual growth to "hit the cap," she said.

"It doesn't matter where the index finishes. As long as you do 11% or more, you are in this bucket, which is why the probability is quite high," she said.

On the downside, the risk of losing more than 15% per year, or about 30% for the term, is 17.6%.

"Again, the probability is high on that end of the chart because it includes all losses from 15% to everything," she said.

Price and overall

Future Value Consultants' estimate of the total costs taken out of the product from direct fees and profit margin on the underlying derivative is calculated on a scale of zero to 10 via the price score.

This product has an 8.75 price score, which is much higher than the average of 5.17 for all products.

"The price score is quite high because compared to the short-dated reverse convertibles, you have a longer duration. A longer tenor is better in that regard since the costs are fixed and the fees are calculated per annum," she said.

"What it means is that the terms offered considering the underlying and the risk-taking are of good value," she said.

Future Value Consultants' opinion on the quality of a deal is expressed in its overall score, which is the average of the price score and the return score.

The notes received an 8.15 overall score against 5.57 for all products and 7.70 for products of the same category.

"You have your two scores - return and price - that are better than the average. It gives you a good overall score," she said.

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