GS Finance’s bearish autocalls absolute return notes on S&P not worth the bet, contrarian said

By Emma Trincal

New York, April 8 –GS Finance Corp.’s $8.08 million of 0% bearish autocallable absolute return notes due April 3, 2024 linked to the S&P 500 index limit the odds of success for investors due to an unfavorable call provision, a contrarian portfolio manager said.

If on any day during the life of the notes the index closes at less than 75% of the initial level, the notes will be automatically called at par, according to a 424B2 filing with the Securities and Exchange Commission.

If the notes are not called and the index closes at or above its initial level, the payout will be par plus 2.5%.

If the notes are not called and the index falls by no more than 25%, the payout will be par plus the absolute value of the index return. If the index declines by more than 25%, investors will receive par.

Any day, rain or shine

“Here is the key issue: the notes get automatically called at par if on any day during the life of the notes the index closes at less than 75%,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

“Because of this, the chance of being called at par is probably 98% or 99%.

“If the call was quarterly or even monthly, it would be much better. But any day?”

Kaplan is bearish on the U.S. market. But in his view, even in a bull market, a 25% drop over the two-year period has a high probability of happening if it’s observed on any trading day.

Call risk, no gain

“If you look back to the past 25 years, you’ll see times when the market declines by 25% or more even when the trend is upward. It’s the inherent nature of the stock market to have periodical drops,” he said.

“Any statistical analysis will show that the chance of not being down 25% in that two-year timeframe is almost zero, especially now with an overvalued market.”

The absence of reward if the notes get called was the main drawback.

“You’ll get called away. You don’t know when exactly but the odds of holding the notes for two years and getting a positive return at maturity are almost non-existent.

The call provision did not feature any call premium, fixed payout or coupon, which for Kaplan was problematic.

“No gain. A call that can be triggered any day. Very odd.

“You’re investing in something that has a very high probability of yielding nothing. This defeats the purpose of a note or any investment for that matter.”

Disappointment ahead

Kaplan said that even for the most conservative investor, the notes may not be a good fit.

“Some wealthy investors want first and foremost some peace of mind. They don’t want to lose money. It doesn’t mean they don’t want to make money,” he said.

The notes indeed offer full principal protection at maturity, sheltering investors from market risk.

“There’s such a high probability of being called due to the daily barrier that you may as well forget about getting 2.5%, let alone the absolute return,” he said.

“So, while you’re not exposed to the ups and downs of the market, you’re clearly wasting your time. Call it opportunity cost. To me, having your money tied up for an unknown period of time knowing that your money is not going to work for you is also some kind of a risk.”

Hoping wrong

It’s the investor’s responsibility to assess the risk-adjusted reward and the chances of success of a trade, he noted. To be sure, buyers of the product are hoping the notes will not get called.

“I think it’s foolish,” he said.

“You have to look at the probabilities. What is the most likely scenario? The call scenario. And which among the three possible outcomes –a 2.5% return, the absolute return or getting par back –is the worst possible one? Obviously, it’s to get par back, which is also the most likely scenario. You’re just hoping that it won’t happen, but the odds are very much against you.

“If the odds of getting 0% are 99%, would you still buy it?

“Even the most skittish investors would not make such a bet. You always hope to get something out of your investment.”

The absence of any payout when the notes get called was one of the main reasons the issuer had been able to price a full-principal protection over a short tenor.

Finish line

Kaplan continued his analysis focusing on the various payout prospects should the notes mature.

“You didn’t get called. It’s a stretch. But let’s look into this,” he said.

“If the market is up, you get 1.25% a year. If it’s down more than 25%, you get the same thing. The only time the note makes sense is when the index is down but not down by more than 25%,” he said.

“That’s the only worthwhile scenario. And again, it’s a very unlikely one. Why? First because as I said you’ll get called away and second because you have to fall within that range and it’s a tiny range.”

There was a third reason.

“So, you’re really betting on the absolute return. But you don’t want the index to be down 2% or 4% at maturity. You want to see a 20% decline for instance, so you get 10% a year.

“At the risk of repeating myself, it’s just not going to happen. You can’t be down 20% at maturity without being down 25% at some point before.”

No teddy bear

For Kaplan, the notes were more of a game of chance than an investment.

“It’s like a carnival game. You think you’re going to get the stuffed animal. You play but they almost never give away the prize,” he said.

Conservative investors have access to other options, which could provide better risk-adjusted returns, he said.

He suggested I bonds. Issued by the U.S. Treasury, I bonds are currently yielding 7.12% per year and are exempt from state and local taxes, he noted.

“If you want capital preservation and still want to make some money, there are better alternatives than this note.”

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

The underwriter is Goldman Sachs & Co. LLC.

The notes settled on Tuesday.

The Cusip number is 40057LLQ2.

The fee is 1.5%.

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