GS Finance’s index-linked notes tied to S&P 500 offer bearish play, full protection

By Emma Trincal

New York, Jan. 10 – GS Finance Corp.’s 0% index-linked notes due Jan. 29, 2020 tied to the S&P 500 index give investors a more conservative tool to express a bearish view than being outright short the index, according to a portfolio manager. It also offers income-seekers an alternative to a bond given the downside protection, said a financial adviser.

If the index return is positive or declines below 82.85% of its initial level, the payout will be par, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is negative but above 82.85% of its initial level, the payout will be par plus the absolute value of the return.

Bearish

Any decline of the index above the barrier will generate a positive return of up to 17.15%. Any other scenario will lead to the mere return of principal with no gain or loss.

Steve Doucette, financial adviser at Proctor Financial, said that what made the bearish notes interesting was the principal-protection component. Because of it, investors had the flexibility to use the product as a fixed-income substitute.

“If you’re a bear, it seems like a great note,” he said.

“You’re betting that the market will go down but not down more than 17%. That’s when you really outperform.

“Even if you go through the 17% barrier, you’re still going to outperform. The market is down 18%, you’ve lost nothing. That’s pretty good.”

Directional

Bear notes are directional investments. Therefore, they differ from the so-called “absolute return” or “dual directional” structures that allow investors to gain on both sides of the market, he noted.

Typical bearish notes reverse the “downside” risk and cause investors to lose money if the market is up.

With this product however, the principal is fully guaranteed in any scenario. But there is a tradeoff, he said.

Once the S&P declines by more than 17%, not only investors cease to participate on an absolute return basis in the downside, they also lose their gain.

“It’s actually not a cap but really a barrier. You make money until you don’t. If you breach, you just get your principal back.”

Fixed-income substitute

Still, getting 100% of principal guaranteed over one year made the notes worth exploring for income-seekers, he added.

“You give up 2% to 5% you would expect from a high-yield money market fund. But if you happen to hit that range...if the S&P is down without breaching, you could make up to 17%. Of course, it could be less. But it could also be more than 3%. You’re tying up your money for one year but you’re not giving up that much,” he said.

Speculative bet

Despite the principal protection and short tenor, Doucette said the notes were still a “gamble” rather than an investment.

“Even as a fixed-income component, you’re speculating. You’re betting on one direction only. When I buy a note, I want to be able to outperform either way,” he said.

“What if the market rebounds and rallies for another year? You could miss out on a bull if you’re wrong. You’ve taken only one side.”

Barrier

Steven Jon Kaplan, founder of TrueContrarian Investments, saw in the note an opportunity to replicate a short position with less risk.

The odds of “missing out on the downside” compared to shorting the index were small in his opinion because one year would probably not be long enough to push down the benchmark beyond the 17% threshold.

“The Christmas sell-off drove the S&P down to low points. The market has begun to rebound and it will rebound further before a big drop. But it takes time,” he said.

“It’s going to be a choppy year rather than a huge bear market, which is good for the notes given that barrier.”

Alternative strategy

Another important benefit of the note was to help investors establish the equivalent of a short position on the market with more ease and less risk.

“If you were short the S&P you would need more capital to cover your position. It would be a much more dangerous place to be in,” he said.

Short-selling exposes investors to unlimited risk if the price rises because the borrowed security has to be bought back after the sale in order for the position to close. In addition, short-sellers incur notable borrowing costs as they trade on margin.

“They came up with a combination of positions that option traders would use for the same outcome and that is making money if the market falls within a range while hedging all other possibilities,” he said.

Short the index, put

He described what would be the equivalent of the notes with the use of an option strategy.

“First you’re short the index fund,” he said.

A short position in the index would provide a one-to-one gain for each point of decline down to zero.

The second leg would be to write an out-of-the-money put 17% below the initial price.

Writing an option is the opposite of being long the position. Put writers bet that the underlying price will not drop below the strike price. If it does, they are in the obligation to buy the shares at the strike level, which would be a loss measured by how far the price drops beyond the strike.

The strike for the short put option position is the equivalent of the barrier in the structured note.

As with the notes, investors will not lose any principal if the index falls below the strike. That’s simply because of the existence of a short position.

“Your short offsets the loss on your put on a one-to-one basis,” he explained.

“That way a drop above the strike would be a gain. Any drop below it would be hedged.”

Hedging with calls

Part of the reason behind selling a put is to generate some premium in order to buy the final leg of the trade, which is an at-the-money call.

“Being long an at-the-money call is your protection if your short position turns out to be wrong and the index goes up instead of down,” he said.

The term “at-the-money” is used when the strike price and stock price are identical.

Any point of increase in the index above its initial level will generate a positive return. However, the call option will not be used to generate gains on the upside. Instead it will be used to hedge the short position on the index in the event of a rally.

Skew

It is not clear whether the put sale would generate enough premium to entirely cover the cost of buying the call, he said.

But using this bearish strategy rather than its bullish counterpart usually called a collar is an opportunistic approach due to the skew between puts and calls, he added.

“Puts tend to be more expensive than calls in general because people want to protect themselves against a big drop. The market is volatile and we had such a serious sell-off during the holidays that puts have been even more expensive.”

This recent trend in the appreciation of the cost of insurance is slowly receding as the market has been rallying since the beginning of the year.

“The timing of this deal would have been better a month ago when everybody was buying protection like crazy.

“But it’s still a pretty interesting strategy,” he said.

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. is the agent.

The notes will price on Jan. 11 and settle on Jan. 16.

The Cusip number is 40056ET73.

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