GS Finance’s contingent coupon autocalls tied to BofA to benefit from Fed’s shift on inflation

By Emma Trincal

New York, Aug. 28 – GS Finance Corp.’s autocallable contingent coupon stock-linked notes due Sept. 15, 2021 linked to the common stock of Bank of America Corp. may benefit from a brand-new change in monetary policy, said a contrarian portfolio manager.

The notes will pay a contingent quarterly coupon of 10.9% per annum if the stock closes at or above its 70% coupon trigger level on the related determination date, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if the stock closes at or above its initial level on any quarterly determination date.

The payout at maturity will be par unless the stock finishes below the 70% trigger level, in which case investors will lose 1% for every 1% decline of the stock.

“This short-term income play on one of the strongest U.S. banks seems reasonable,” said Steven Jon Kaplan, founder, and portfolio manager of True Contrarian Investments.

“I also like the one-year period.”

But more than the duration of the notes, which the autocall could shorten into one quarter, Kaplan focused on the timing of the pricing as it occurred only a day after a major shift in the Federal Reserve policy.

Fed’s new take on inflation

On Thursday, the Federal Open Market Committee announced changes in its “longer-run goals and monetary policy strategy,” allowing inflation to rise “moderately above 2% for some time,” a departure from inflation targeting which led the Fed in the past to hike short-term rates as soon as inflation was rising. From now on, the Fed gives itself the flexibility to let prices rise above the 2% target if it deems it necessary to strengthen a weak labor market.

Analysts concluded that the new guidelines announced in a speech by Fed chairman Jerome Powell are likely to keep short-term interest rates low for a very long time as the Fed is now pursuing a new agenda of higher inflation.

Banks’ margins

In reaction, the yield curve steepened on Thursday. Share prices of banks rose at the end of the day, with Bank of America finishing up 2.2% higher on the day after the speech.

“A steeper curve is a very good thing for banks,” said Kaplan.

The greater spread between short-term and long-term rates will improve banks’ margins as banks borrow on the short end and lend on the long end, he explained.

Short-term rates set by the Fed are the rates at which banks borrow from either the Fed (discount rate) or other banks (Fed Funds rate).

The Fed on the other hand has less influence over long-term rates, which are determined by supply and demand for bonds among market participants.

“The Fed appears to be changing its traditional model of setting an inflation target,” said Kaplan.

“It looks like they’re willing or even encouraging inflation to increase.”

As the Fed signaled its intent to be more lenient toward inflation, the market will start to sell long-term bonds, which will steepen the yield curve, he said.

“If you have inflation, long-term rates will go up. It’s how the market operates.”

Barrier at a low

Those positive developments should remove some of the downside risk associated with a possible barrier breach.

“On the fundamentals, a Fed no longer willing to fight inflation is going to benefit banks’ margins,” he said.

“So, I think that the risk on the downside is probably small.”

From a technical standpoint, Kaplan doubted the stock would be falling by more than 30% at maturity.

“The stock had a big drop in March. Now it has rebounded, but it has been a choppy recovery and it’s still down a lot from its previous high,” he said.

The stock closed at $26.30 on Friday, which was the pricing date.

The share price bottomed on March 23 at $17.95 from a $35.72 high in December.

The barrier level would be $18.41, which is very close to the low of March, he noted.

“What are the chances that a year from today, the stock would decline to its March low?” he said.

“That’s the real question.

“It is possible. But I think interest rates will go up in 2021. So, for a one-year period, I would say the probabilities of hitting this barrier are very low. Not zero, but I don’t see a high risk of that happening.”

Volatility ahead

The shift in the Fed’s monetary policy may be good for banks, but not necessarily good for the economy, he said.

“Without the Fed’s commitment to raise rates as soon as the first signs of inflation appears, we will see a return of inflation.

“People haven’t seen inflation for 30 or 40 years. They think it won’t happen again. They forgot its negative impact as we saw it in the 1970s.”

Kaplan said he foresees a market correction later this year in the aftermath of the Elections extending to the early part of next year.

The first observation date is on Dec. 10, according to the prospectus.

“Dec. 10 will probably be close to the year-end bottom, so I don’t see a high probability of getting called then.

The most likely outcome for noteholders is a call happening around the middle of next year, he predicted.

Seasonal trends

Kaplan said he factors in seasonality in his forecasts.

“Most assets tend to peak around the time of maximum increasing sunlight from April to June and bottom during maximum decreasing sunlight between October and December,” he noted.

“So, I would guess June would be the most likely time for the note to be called.”

It would be a mistake for investors to dismiss or underestimate well-established seasonal trends that tend to impact the stock market year after year, he said.

“Sunlight affects behaviors and moods. Many studies have demonstrated a relationship between sunlight and equity prices,” he said.

“By June, the market will be up. If the notes are called at that time it will be a good thing. You should have collected some coupon payments along the way. And the call removes your risk.

Overall, Kaplan liked the notes even though the entry point was not optimal.

“This deal makes sense based on improved fundamentals for banks.

“Personally, I might have preferred to do it last March or to wait maybe until late November at a time when the stock would probably be lower, so you have less to worry about the 30% drop.

“But your chances of getting called are high, so you should have a reasonable chance of getting a decent return.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The notes will settle on Sept. 2.

The Cusip number is 40057CPV7.

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