Buffer on GS Finance’s $1.3 million leveraged notes on S&P: too small to work, contrarian says

By Emma Trincal

New York, April 5 – GS Finance Corp.’s $1.3 million of 0% leveraged buffered index-linked notes due Oct. 1, 2025 tied to the S&P 500 index introduced a feature rarely seen: the leveraging of the absolute return on the downside by more than 100%. But a contrarian portfolio manager said the real value of the note was its plain buffer, not its leverage, however sophisticated the feature was. He objected to the buffer however because of its size, which he said was too small to offer the adequate protection required in an upcoming bear market, he said.

If the index return is positive, investors will receive par plus 120% of the index gain, capped at par plus 10.25%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is flat or falls by up to 15%, investors will receive par plus 120% the absolute value of the return.

Investors will lose 1% for every 1% decline beyond 15%.

Not enough

“There’s a buffer, which is a good thing. They had to cap the notes to be able to pay for it,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The absolute return was capped at 15%, which was the equivalent of a 9.8 % annual return on a compounded basis. For the upside, the 10.25% cap limited the gains to 6.7% per annum.

“This would appeal to people who think the market is going to go sideways.”

The note did not pay the 1.4% index dividend yield, he noted, or about 2% for the period.

“You could argue that the buffer makes it safer. You may also want to use it as a source of income.

“But the 15% buffer wouldn’t protect you against a big drop and the chances of the market falling by more than 15% are pretty high.

“The note is not the problem. The market is the problem.”

Kaplan said the stock market was in a bubble. Investors’ propensity to buy “anything related to AI” suggested that the market had adopted a speculative behavior pushing stock prices well above their intrinsic value.

Bubble

“It will be almost impossible to make money in the stock market in the next three years no matter what you do.”

Both the S&P 500 index and the Russell 2000 index are trading double their respective fair value, he said.

“AI stocks are four to five times their fair value and that includes Tesla despite its drop.”

The stock of the electric vehicle company has fallen 44% from its one-year high in July.

“The S&P is overvalued and overbought. Sentiment is exuberant. The S&P has reached all-time highs. Investors buy anything that’s going up and that’s never a good reason to buy.

“Most people should have their money in Treasuries for the next three years where you can get 5% guaranteed.”

Keep it short

The advantage of structured notes, he said, is the protection they provide, especially through buffers.

“That’s what I like about this security. Unfortunately, 15% is not enough. Stocks will drop more than that.”

Kaplan would not extend the duration of the notes.

“Eighteen months is fine. The further you go, the greater the risk of losses. Bear markets tend to have their biggest losses towards the end. We also had the longest bull market in history since 2009. The bear market will be long as well. With an 18-month you may be lucky.”

He pointed to the accumulation of bearish signals in the market, citing a record inflows into U.S. equity funds, an all-time record insider selling and the highest-ever valuations if measured by price-to-sales and price/earnings-to-growth ratio, or "PEG.”

Doubling up

If he had to change the structure, the portfolio manager would try to solidify the downside protection.

“I’m not sure you could get a 30% buffer on a short period of time, but it would be much better. You would have to give up some of the upside, which is already capped anyway. The leverage on both sides looks attractive but you could easily get rid of it and not lose much. I would make both the upside and the absolute return one-to-one. On the downside for sure because the odds of a drop below the buffer are so high. The leverage here is not doing much for you.”

Heading for extremes

For Kaplan, the note expressed a view, which he said was unlikely to materialize.

“You expect the market to be range-bound but given where we are it’s probably not going to be the case,” he said.

“The market will either go straight up or straight down and collapse.

The stock market has been rallying since October, he noted, jumping close to 30%, which he said is not sustainable for a long time.

“Most likely we’ll have another big drop or a large rebound. But it’s not going sideways.”

Market sentiment will play a key role in this momentum-driven environment.

“If investors continue to speculate paying no attention to profit growth, the market could be going up fast, but it should go down even faster. In this type of environment, you get a lot of ups and downs. You don’t have a range-bound market,” he said.

Puts for sale

As an alternative to a buffered note, investors could buy put options.

“Buying puts is inexpensive. Protection is cheap,” he said.

Put options are at their most undervalued level relative to call options since 1973, he added.

“Puts are a good way to protect a portfolio although it’s hard for the average person to do it,” he said.

A good approach is to buy in-the-money puts as they already have some intrinsic value, he added.

He offered an example.

The “at-the-money” price of the S&P is at approximately 5,200. If one buys a six-month put with a 5,600 strike, the put is “in-the-money” since the current price of the index option is lower than the strike price. The put has intrinsic value because it could be sold at a profit expressed by the difference between the strike price and the at-the-money price, he explained.

“But options are not for everyone. This is one of the reasons buffered notes are popular. You do want to get the right buffer though,” he said.

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The notes settled on March 28.

The Cusip number is 40057YU92.

The fee is 2.45%.

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