Advisers compare value of one-year call premium versus leverage, protection at maturity

By Emma Trincal

New York, Nov. 28 – Two issuers recently priced three-year note offerings including a one-time autocallable after one year, and if the call does not occur, uncapped upside leveraged participation at maturity. Both deals had comparable terms, including a double-digit call premium and priced on the same day. One important distinction, however, was that the first one was built on a single underlier and paid a lower call premium.

Bank of Montreal priced $1.86 million of 0% market-linked securities – autocallable leveraged upside participation and contingent downside due Nov. 24, 2025 linked to the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

The securities will be automatically called at par plus a 14.5% call premium if the index closes at or above its initial level on Nov. 24, 2023.

The payout at maturity will be par plus 150% of the gain in the index.

The structure featured a 70% barrier for the downside protection.

Separately, GS Finance Corp. priced $1.66 million of 0% autocallable index-linked notes due Nov. 21, 2025 tied to the S&P 500 index and the Russell 2000 index, according to a 424B2 filing with the SEC.

If each index closes at or above its initial level on Nov. 20, 2023, the notes will be called at par plus a 17.2% call premium.

If the notes are not called and each index finishes at or above its initial level, the payout will be par plus 1.25 times the return of the laggard index.

The downside protection was provided by a 20% buffer applied to the worst performer.

No worst-of, please

“Those two deals are very much alike, but I would do the first one. And the reason is simple: I don’t like worst-of. It’s just adding another variable you don’t need. I like the notes with exposure to one index better,” said Carl Kunhardt, wealth advisor at Quest Capital Management.

The first deal offered more leverage, another advantage, he noted.

“And even though it’s a barrier, not a buffer, I’d still go with the barrier because I just don’t do worst-of.”

The downside was the lower premium of 14.5% compared to 17.2% for the GS Finance notes.

“I’m sorry if 14.5% is too low for you. To me, it’s just fine,” he said.

“Anyone who’s convinced that the notes will get called in one year is going to choose the other deal, the one with the highest call premium.

“But how do you decide whether it’s going to get called or not unless you can see the future?”

Bullish at maturity

For the three-year timeframe, Kunhardt said he was bullish.

“We already start to see inflation kicking down. Whenever the Fed does something, you don’t see the impact on the first six to 12 months. They started in March first with 25 basis points and accelerated with 75 bps hikes. Everybody worries about the Fed throwing the economy into a recession. A hard or a soft landing? It’s a fool’s game to guess the market that way,” he said.

Risk-adjusted return

“Do I think the market will be up in a year? Yes, I do. Do I have enough conviction to be shooting for 17.2% instead of 14.5%? No, I don’t.”

As a financial planner, Kunhardt said his role is to maximize returns without increasing volatility. The notes with the lower premium of 14.5% met such goal as they come with less volatility, he said.

“It’s a single underlier, a large-cap index whereas the other is a worst-of that includes the Russell 2000. As soon as you’re moving into small-caps you’re going to have more volatility. You changed the dynamics.

“As a financial planner, taking the extra risk for an additional 2.7% is not worth it,” he said.

Bigger call premium

Steven Foldes, wealth manager and founder of Evensky & Katz / Foldes Financial Wealth Management, said he would choose the GS Finance notes on the view that the notes should be called in a year.

“I prefer the second one, the worst-of with the highest call premium,” he said.

He offered several reasons.

“First, I don’t know Bank of Montreal. I’d rather go with Goldman Sachs. I’m familiar with their credit.

“Second, the correlation between the S&P and the Russell 2000 is quite high. It’s likely that if one is positive, the other one would be positive as well.

“Third, the premium differential – 17.2% versus 14.5% – is not inconsequential.

“Fourth, I much prefer a 20% buffer than a 70% barrier.

“Finally, the second deal has a lower fee.”

The BMO notes carry a 2.425% fee; the fee for the GS Finance deal is 2%, according to the notes’ respective filings.

Getting more leverage

Perhaps what drove Foldes’ choice the most was the assumption that the notes would not mature.

“I’m not expecting to go three years,” he said.

“We’re having a bad year. We’re down close to 20%. My guess is that the market will be up in 2023. By then, the Ukrainian war should be resolved, maybe or maybe not since it’s been going on for nine months already. But the issue with the Fed tightening at least should be behind us.”

Foldes would reduce or eliminate the buffer in order to enhance the leverage should the notes mature.

“Although it’s nice to have a buffer, I don’t think you need one on a three-year timeframe and at current market levels. I would do away with the buffer and try to get more leverage instead.”

Short-term bull

For Foldes, the difference in premium between the two notes mattered.

“You have to look at things on a relative basis.

“I’m optimistic enough to believe that there wouldn’t be a second year.

“All you need really is both indices to be up a year from now. I think it’s very likely to be the case.

“When you’re coming off a year where you’re down 17%, probably more after today, there’s a very high likelihood that the following year will be a pretty good year. That’s why I’d like to see a higher coupon,” he said.

On Monday, the S&P 500 index dropped 1.45% and the Russell 2000 index shed more than 2%.

“I’m optimistic that we’re going to see positive returns next year because what caused the market downturn was not Covid, it was not the war in Ukraine, it was the Fed’s tightening policy. That’s been the big driver. By next year, the Fed should have slowed the pace of rate hikes if not reversed course,” he said.

The agent for the BMO offering is Wells Fargo Securities LLC.

The Cusip number is 06374VE36.

The GS Finance notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. LLC is the agent.

The Cusip number is 40057NSH1.

Both deals priced on Nov. 18 and settled on Nov. 23.

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