GS Finance’s contingent income autocalls on three tech stocks tap into correction opportunity

By Emma Trincal

New York, Sept. 18 – GS Finance Corp.’s 0% contingent income autocallable securities due Sept. 28, 2023 linked to the worst performing of Apple Inc., Amazon.com, Inc. and Microsoft Corp. come at the right time for investors seeking higher yields after the mega-cap tech stocks continued to suffer extended losses leading the rest of the market to a third week of decline.

“Those three stocks have rallied considerably for more than five months, helping the overall market recover after the sell-off in March,” said Tim Mortimer, managing director at Future Value Consultants.

“Now they’re under pressure, which is not a bad thing if you want to strike better terms.”

Each quarter, the notes pay a contingent coupon at the rate of 11.4% per year if each stock closes at or above its trigger level, 60% of its initial level, on the observation date for that period, according to an FWP filing with the Securities and Exchange Commission.

The notes will be automatically called at par if each stock closes at or above its initial level on any quarterly call date.

The payout at maturity will be par unless any stock closes below its 60% trigger level, in which case investors will lose 1% for every 1% decline of the least-performing stock from its initial level.

“There’s definitely a correction in the tech sector. But so far it hasn’t been quite as drastic as what we saw back in March,” he said.

High-flyers

The U.S. market went through a brief but steep crash between mid-February and March 23 induced by the Covid-19 pandemic.

Apple shed 35% during those few weeks, while Amazon dropped 30% and Microsoft, 26%.

From the March lows, all three stocks pushed up vigorously leading them to record highs on Sept. 2 at a pace strong enough to drive the rest of the market on a fast recovery path.

During the five-and-a-half months, Apple surged 200%, Amazon climbed 118% and Microsoft rose 76%.

The September sell-off does not compare with March, at least not yet. Still Apple, which closed at $106.84 on Friday, is down 22% from its high, losing 3.17% on Friday alone. Amazon and Microsoft have already dropped 17% and 14%, respectively, from their Sept. 2 all-time highs.

Now what?

“There’s been a shift in market sentiment after the crash in March in favor of big-tech. Those stocks have skyrocketed. This recent sell-off is giving them a much more reasonable value compared to a few months ago,” he said.

“Every time there is a sell-off people must make a decision: do they want to strike at those lower prices and get better terms or should they wait?”

This type of uncertainty itself is fueling volatility as investors do not know if the bears will have the upper hand or not.

“Bulls may consider that Apple, Microsoft and Amazon are stellar names and that it’s a good time to monetize the volatility,” he said.

“We’ve already had a rise in volatility because of what’s going on this year. It’s pretty clear that the future is uncertain when you look at the U.S. Presidential Elections, China, and obviously, Covid.

“Now with the sell-off, there is even more volatility. A correction is not a bad place to start.”

Volatility

Microsoft is the less volatile of the three with an implied volatility of 29.9%. Apple at 34.46% is the most volatile, closely followed by Amazon with a 33% volatility, he said.

Those levels of volatility may be high, the amplitude of the tech correction uncertain. But Mortimer said the 60% barrier was still “pretty good.”

“The annualized 11.4% coupon is also quite attractive,” he noted.

High correlations

When investing in worst-of notes, buyers should consider the risk associated with dispersion of returns. The higher the correlation between the underlying, the lower the risk.

“Those stocks are correlated to one another. The correlation is about 90%. These are pretty high levels,” he said.

Correlations between U.S. equity benchmarks tend to be closer to 100%, usually, around 96% or 97%. But for stocks, a 90% correlation is on the higher end of the spectrum, he said.

“Indices would be more correlated, but you can’t compare it with stocks. Different things can happen to different stocks. Amazon caters to the retail sector. Microsoft does business computing. Apple manufactures smartphones, tablets and computers for retail,” he observed.

“They are in different areas. A corporate issue, a global threat from a competitor or a regulatory change can affect one but not the others.”

First call

Future Value Consultants offers stress testing on structured notes encompassing simulation tables as well as back-testing analysis. Mortimer analyzed some of the results displayed by the report he generated for this product.

One of the tables included in the report, called the scorecard, displays probabilities associated with various outcomes. For this product type, the tests include probability of barrier breach, probabilities of call at various dates and probability of full capital return.

Investors have a 36.63% chance to see their note called on the first date after three months, or “at point 1,” according to the scorecard.

“It’s quite low and the reason for that is the worst-of. Usually the probability is more like 50% but worst-of are different since it’s not as easy to call when you look at three stocks or even two.”

With single asset autocalls, the chances of a call drop very rapidly after the first observation, he said.

“Here, you have an 11% chance for the second call, which is higher than normal. The call stands up reasonably well,” he said.

Mission accomplished

One of the three outcomes – “full capital return” – represents a situation in which the underlying closes within the barrier zone. The final price will be at or above 60% (which rules out the breach) and below 100% so that there is no call, which will distinguish the outcome from the “call at point 12” bucket.

“You haven’t hit the barrier and you’re getting your last coupon,” he said.

The probability for this scenario is 9.92%.

Hard losses

When the worst-of drops below 60%, investors fall into the “total return loss” outcome. The odds for this worst-case scenario to occur are not negligeable at 21.91%. When the barrier is breached, investors lose 46.32% on average, the table shows.

“The amount of losses suffered by investors if one of the stocks drops more than 40% is significant. It would be quite painful,” he said.

“But this is only the simulation.

“If you look at the back-testing, the results are quite different. What has happened offers a much brighter picture.”

The back-testing version of the scorecard provides data going back five, 10 and 15 years.

“Over the past five years you never lost money... over the last 10 years, you didn’t either. There’s a tiny 0.34% chance of losing over the last 15 years.

“Given the run that the three stocks had, there’s nothing surprising about that.”

Barrier

The notes will price at the end of the week.

Investors will have a chance to observe how the tech sell-off unfolds, he said.

“40% as a protection for these three names I think is a big cushion. Of course, it’s always possible to breach, but it’s a long shot.”

The share price of Apple hit the barrier threshold as recently as April, however, when the stock was trading just below $60. The barrier level would be at $64.10 as of Friday’s close.

“It hit not a long time ago. But we’re having a correction. Also, it’s a three-year note and the 60% barrier is point to point. It would have to fall and stay at that level at the end,” he said.

For investors, the best-case scenario would be to see the notes mature with a price comprised between the worst-of barrier level and the maximum amount of coupon payments, or 34.2%.

“That’s the sweet spot,” he said.

Asset allocators may wonder where they should allocate the notes in the portfolio since the notes offer a mixed profile of high equity return and income.

Mortimer said his firm offers a tool allowing investors to decide where a note may best fit into a portfolio.

Ultimately, investors’ views on the market and their risk tolerance will determine their decision to buy or not.

“Investors can’t be too bullish. If you think it can go above 134%, you’d be better off buying the shares.

“On the downside, this note gives you the income stream that one looks for in a bond.

“But it’s a very high yield and you get it by substituting credit risk for equity risk. So, unless you’re willing to take on some market risk, you probably shouldn’t consider the notes. You probably shouldn’t be buying equity in the first place either,” he said.

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the underwriter. Morgan Stanley Wealth Management is acting as dealer.

The notes will price on Sept. 25 and settle on Sept. 30.

The Cusip number is 36259L683.

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