GS Finance’s autocalls on three indexes offer high return, but barrier seen as too thin

By Emma Trincal

New York, Oct. 15 – GS Finance Corp.’s 0% jump securities with autocallable feature due Oct. 29, 2026 linked to the worst performing of the S&P 500 index, the Topix index and the Euro Stoxx 50 index, provide global equity exposure with an attractive call premium, but the size of the barrier is not defensive enough, said Clemens Kownatzki, finance professor at Pepperdine University.

The notes will be called at par of $10 plus an annual premium of 13.5% if each index closes at or above its initial level on any annual observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 67.5% if each index finishes at or above its initial level. If the worst performing index declines by no more than 20%, the payout will be par. If the worst performing index finishes below its 80% downside threshold level, investors will be fully exposed to the decline.

Low correlations and a tight barrier were some of the weak aspects of the deal, Kownatzki said. However, the upside payout was attractive.

Kownatzki first noted the gaps in performance between the three different markets of Europe, Japan and the United States.

“Over the past five years, the S&P 500 index has more than doubled. The Euro Stoxx 50 has gained 42% and the Topix, 47%,” he said.

“Even over the course of the last decade, the S&P by far outperformed the two other indices.”

Correlations

He then proceeded to study the correlations between the three indexes during last year’s pandemic-induced sell-off in March.

“We typically see increased correlations during bear markets. But during last year’s pullback, correlations between the three indices were surprisingly low. I was expecting the opposite during that brief but challenging period,” he said.

The daily correlation between the three indexes in the first half of 2020 was 0.23 between the S&P 500 and the Topix, 0.60 between the S&P and the Euro Stoxx and 0.42 between the Euro Stoxx and the Topix.

“This tells us that correlations between those indices are intrinsically low because what we normally expect in a crisis is to see correlations going to 1,” he said.

“During the 2008 crisis, correlations jumped dramatically.

“So, this is an interesting one. And that’s not such a good thing. Low correlations in a worst-of increase the chances of breaching the barrier.”

Call premium

On the other hand, he said the payout on the upside was attractive.

“Obviously, what’s appealing here is the 13.5% premium. But it’s not just that. It’s also the fact that you can get it even if the market is flat.

“And if you miss one or several payments, you possibly get paid later.”

Investors are used to high double-digit returns in equities. But those gains are above historical averages, he said.

“If you expect moderate return over the next five years, if you anticipate a reversion to the mean, this note is attractive, no question,” he said.

Mean reversion

Those mean reversions however do not always happen gradually, he noted, adding that the risk of a severe downturn cannot be overlooked.

“We could have turbulent markets before prices revert back toward their average,” he said.

“If we see a bear market in the next five years, then you have a problem because the 20% protection is not a lot.,” he said.

One risk mitigation factor remained the role of central banks, whose interventions may support the economy and the markets, potentially reducing the length or the severity of a crisis.

QEs to the rescue

“It has become increasingly difficult to predict the future direction of the stock market because of the growing role of central banks in most developed countries,” he said.

“Clearly, they are no longer independent from the governments.”

The message was clear in Europe when European Central Bank president Mario Draghi famously said in 2012 that the ECB would do “whatever it takes” to stabilize the markets amid the sovereign debt crisis, he said.

Central Banks have implemented quantitative easing policies, expanding their balance sheets in the United States, Europe and Japan.

“The Japanese central bank is the biggest holder of equities in Japan. In the U.S. the Fed has bought Treasuries and mortgage-backed securities. But they went as far as purchasing junk bonds in ETFs,” he said.

The QE program in the U.S. – $120 billion a month – has provided support to the stock market and fueled the rally following last year’s sell-off, he noted.

Fed put

“The Fed has a huge impact on financial markets,” he said.

“They recently said they’re ready to begin tapering. They’ll start reducing the size of the $120 billion a month stimulus. But they won’t stop it. It’s just not going to be on the same scale.”

Even if the focus right now is on tapering, Kownatzki said that the Fed would likely redeploy aggressive QE programs as soon as the first signs of a financial crisis would emerge.

“Push comes to shove, if we see a bear market, the Fed will be under pressure to intervene and take emergency actions to support the economy. If it means buying risky assets, like stocks, they may do it.

“We haven’t had a financial crisis. We had a health crisis,” he said.

“So, the notes, just like the rest of the market, may benefit from the Fed’s determination to do what’s necessary to keep the market afloat.”

But Kownatzki still considered the note too risky.

“What’s difficult to assess is the timing. From the perspective of the note, and despite all the monetary policy tools the Fed has at its disposal, I still see risk on the downside,” he said.

“I’m not comfortable with a barrier that tight.”

The notes will be guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. is the underwriter with Morgan Stanley Wealth Management as a dealer.

The notes will price on Oct. 26 and settle on Oct. 29.

The Cusip number is 36261U408.

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