GS Finance’s $12.78 million bear notes on S&P 500 offer principal-protection, hedge

By Emma Trincal

New York, Oct. 26 – GS Finance Corp.’s $12.78 million of 0% bearish barrier market-linked notes with daily barrier observation due April 24, 2023 linked to the S&P 500 index provide potential gains in a down market along with full principal protection over a short maturity. The notes are best used as a tactical trade or a pure hedge to the portfolio, sources said.

A barrier event will occur if the closing level of the index is less than the lower barrier, 79.25% of initial level, on any day during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

If a barrier event occurs, the payout at maturity will be par plus 10%.

If a barrier event does not occur and the final level of the index is greater than or equal to its initial level, the payout at maturity will be par. Otherwise, the payout will be par plus the absolute value of the index return.

Knock-out trade

“I see. We’ve seen that kind of barrier before. It’s an American knock-out barrier. The option is worthless once you hit the strike. It’s an American option, meaning it can happen any day,” a financial adviser said.

American options designate the daily barrier observation used in the structure to determine the payout at maturity. Most barriers in structured notes are “European,” which means they are observed upon the expiration of the option, or the maturity of the notes.

“You’re good as long as you don’t knock out on the downside. If you do, if at any time the index drops more than 21%, you lose the benefit of the note since you’ll only get 10% at maturity, best-case scenario. The saving grace is you get your principal back,” he said.

The barrier is breached beyond 20.75%, which he rounded up to 21%.

Directional, non-directional

“The absolute return is the main benefit of note. But it only pays off if you’re down,” he said.

The asymmetrical return was not appealing to this adviser.

“It’s a bearish note. It reflects a very specific view. We’ve done other types of knock out notes with upper and lower barriers. Those are much more attractive in my opinion,” he said.

He described a deal he recently purchased: a two-and-a-half year note with a range of positive returns comprised between -20% and +20%. If the underlying never moves outside of the band on any trading day, investors get the absolute return both on the upside and on the downside. If the barrier is breached at any point, they will receive a fixed payout of 6% at maturity regardless of the final level of the index. Therefore, the principal is also fully guaranteed.

“I like it much more because it’s really a dual directional trade,” he said.

“You don’t have to be limited to one side. That said, ours is a longer-dated note. The choice between a six-month and a two-and-a-half-year is totally subjective. It has to align with your view.”

The GS Finance note, he added, falls under the category of a “tactical” bet.

“The one that we did is for folks that don’t have a strong opinion one way or the other. It’s more of a strategic play. Generally, clients prefer the strategic approach,” he said.

Tiny bonus

One problem with the bear note was the low return offered if the market finished higher.

“1% in six months, which is 2% a year, that’s a far cry from the 4.5% yield you get on a one-year T-bill,” he said.

On the positive side, the full principal protection may prove useful for risk management purposes.

“It’s a good hedge. It’s definitely cheaper than buying a put,” he said.

“If your put expires worthless, you’re net debit. With this, you’ll either get a positive return or 1%. Worst-case scenario, you only get your money back. It’s a positive carry hedge. No gains, no losses. But at least, it cost you nothing to put the hedge on.”

Unpopular notes

There is not an abundant supply of bear notes in the market, including during bear markets, he said.

“In a large part, it’s a matter of education. Many advisers don’t even know that options exist and those who are more knowledgeable are squeamish about putting on tactical trades. They don’t want to take the risk of being wrong. That worries them more than anything else,” he said.

Revcon alternative

A market participant said the notes did not fit his market outlook. But the full principal protection could be helpful.

“Potential applications of this note are wide. But if I really think the market can be down up to 21%, I’d rather buy a longer-dated guaranteed coupon reverse convertible on the S&P,” he said.

He pointed to deals offering more than 8% per annum fixed rates on the S&P 500 index with “deep,” barriers.

“I understand that you don’t get the main benefits of this deal. Your principal is still at risk and it’s not going to be a short-term paper.”

This market participant’s preference for autocallable structures as a way to navigate a down market reflected his market outlook.

“I am not super bearish. I don’t believe I can maximize my return on the downside using that kind of payout with that kind of barrier. If the market is slightly down, I won’t get much with the absolute return. I’m better off with a 30% barrier and an 8.5% guaranteed coupon if my view is range bound or moderately bearish, which it is.

“Rates are up, so you can price out attractive terms on a single index product.”

However, this market participant also liked the use of the notes as a risk mitigation tool.

“It’s a bearish bet with principal protection,” he said.

“People may buy it as a hedge to their portfolio.

“In that case, it makes sense. You may not make a ton of money in the short-term, but if the market tanks, you can potentially benefit from it.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC and UBS Financial Services Inc. are the agents.

The notes settled on Monday.

The Cusip number is 40057NMM6.

The fee is 0.6%.

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