GS Finance’s $1 million bearish absolute return notes on S&P offer hedge, alpha

By Emma Trincal

New York, June 30 – GS Finance Corp.’s $1 million of 0% bearish absolute return index-linked notes linked to the S&P 500 index due July 24, 2024 caught advisers’ eyes for two main features – the full principal protection and the leveraged absolute return on the downside.

If the index finishes at or above the initial level, the payout at maturity will be par, according to a 424B2 filing with the Securities and Exchange Commission.

If the index declines by no more than 40%, the payout will be par plus 1.22 times the absolute value of the index return.

If the index declines by more than 40%, the payout will be par.

“That’s a really bearish note. A pure hedge,” said Steve Doucette, financial adviser at Proctor Financial.

“You could make close to 50% on the downside if the market collapses and stretches to that -40% level. That’s insane.”

Opportunity cost

Unlike many recent bearish notes, investors in this trade will incur no losses if the underlying finishes up or if it drops below the barrier level, he noted.

“You can use it to protect your exposure and since you’re not losing anything on the upside, it’s a pure hedge,” he said.

Not many investors are fully bearish in the current market environment. If used as a hedge, the note needs to be carefully allocated.

“How much of a hedge do you need in your asset allocation? That’s the hard part since no one knows when and by how much the market could go down,” he said.

Because the gains offered by the note in a bear market may be substantial, the position could remain modest in size.

“A market decline from 0% to -40%...that’s a huge range,” he said.

“Since it’s principal-protected, the real downside is the opportunity cost,” he added.

“Worst-case scenario, you’re holding this for a year, and you just get your money back. But if you only put like 5% in it, you’re not missing out that much on the upside.”

Hedge

As an asset allocator, Doucette said he would use the note for protection.

“It looks like a tempting trade when you consider how much you can make in comparison to the low risk you’re taking. But I think it’s more of a hedge and it’s a great hedge,” he said.

Ordinary income

The gains generated by the investment are likely to be treated as ordinary income for tax purposes, according to the prospectus.

“That’s not the most favorable tax treatment. But that’s not a risk. That’s just taxes. If you make a lot of money, yes you have to pay taxes,” he said.

“For somebody in a high tax bracket though, having to pay 40% in taxes could be a problem. I guess that’s the only downside I see with this note.”

Five versus zero

Carl Kunhardt, wealth adviser at Quest Capital Management, was also “interested” by the payout.

“You can make a lot of money in a pretty severe bear market, and you have no exposure to market risk,” he said.

“I might do it. But that wouldn’t be for the principal-protection. The fact that it’s principal-protected is not a selling point for me.”

He pointed to the opportunity cost, which may be measured against the return earned in a safe asset, such as Treasuries or cash equivalent.

“Your risk is to lose the 5% you could get from a money market fund. That’s the opportunity cost. Your risk – and that’s the only one – is to generate zero return,” he said.

It’s the economy

Kunhardt, who is not inclined to be bearish, said however that some economic data were concerning.

“I would look at it from a macro perspective. Is there a risk that the market will be down over the next 13 months? Yes, there is,” he said.

As the economy is facing some headwinds, Kunhardt said the note could be used to protect investors’ portfolios against the risk of a recession.

“We just had the figures for GDP. Q1 was up 2%. It looks good, but that follows a 2.6% increase in Q4 and before that, a 3.2% growth in Q3. That’s not a good trendline. Companies are not investing new capital. Inflation has cooled. It’s no longer at 9%. But it’s still running at 4%, well above the 2% target,” he said.

Kunhardt said the notes offered a “very good hedge,” warranting a position in the alternative investment portion of his portfolio.

Risk reward

For “traders or brokers” driven by the perspective of a high potential reward, the note was “striking” for its risk-adjusted return.

“If the index goes down to 40% you can get almost 50% in about a year without taking the risk of losing any money,” he said.

“That wouldn’t be my approach. I am a planner, not a broker. But it’s still fascinating.

“It’s hard to see how they were able to work the numbers. My guess is that they customized that deal for one of their clients. They’re probably not offering it to anyone else,” he said.

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

Goldman Sachs & Co. LLC is the agent.

The notes settled on Thursday.

The Cusip number is 40057TCR3.

The fee is 0.81%.

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