GS Finance’s digital notes on SPDR S&P Regional Banking seen as too risky due to valuations

By Emma Trincal

New York, Oct. 12 – GS Finance Corp.’s 0% digital notes due Oct. 30, 2019 linked to the SPDR S&P Regional Banking ETF do not meet the criteria of a value play as the fund remains richly valued compared to recent years, said Steven Jon Kaplan, founder and portfolio manager at True Contrarian Investments.

If the ETF return is greater than or equal to its initial level, the payout at maturity will be par plus the maximum settlement amount, which is expected to be $1,112.6 for each $1,000 of notes, according to a 424B2 filing with the Securities and Exchange Commission.

If the ETF falls by up to 20%, the payout will be par.

Otherwise, investors will lose 1% for each 1% decline in the ETF.

Richly valued

While some investors have expected strong growth from regional banks compared to big banks, performance has been disappointing this year. Down 5% since January, the underlying fund has only slightly outperformed the SPDR S&P Bank ETF – its big banks’ counterpart – which is down 7%.

Still, the regional banks fund is not cheap, argued Kaplan. Since a low in February 2016 at $31.00 per share, the ETF has surged 80% to $56.00 on Friday.

The recent sell-off is providing a lower entry. But it’s far from being enough, he said.

“At least you’re getting a little bit of a discount compared to a month ago, but it’s still too soon,” he said.

Far from the lows

He is making that call looking back at least three years.

“When you look at valuations compared to the February 2016 low or even to September of last year when the fund was trading at $48, you can see that this sector is overpriced like most assets in the market,” he said.

“If it goes down to the 2016 lows, it would be almost half of the price. There is a real risk of a drop of 20% if it goes back to those levels.”

Part of the problem with the notes was the downside.

“You can certainly use 20% in protection. But the barrier is problematic. When it breaches it’s a sudden shift. It definitely doesn’t have the same value as a buffer,” he said.

The notes are only a one-year trade. Still, Kaplan always wants to look far back in time to assess the value of an investment, even if it is a short-term deal.

“It’s worth looking back. Even since 2015 the fund today is still trading 50% higher. You don’t want to get in at these levels. Markets are very cyclical. It is important to respect extremes in both directions,” he said.

Economic clouds

Kaplan also considers economic factors. While the U.S. is showing a strong growth, a tight labor market and so far contained inflation, his outlook is negative on the economy as he expects a slowdown in the next two years.

“If we do see an economic downturn, banks that are in the business of lending money will get hit,” he said.

Some local considerations may affect regional banks especially in states suffering from a housing crisis like California.

“A pick up in mortgage defaults could put some of those banks at greater risk,” he said.

Entries matter

Current valuations for the underlying in the notes along with the absence of a buffer made this adviser uncomfortable.

“The chance of a 20% drop in a year is very high,” he said.

“I would want to see a buffer for this note, preferably one that is also a 20% protection.”

If the buffer is impossible to price, Kaplan would extend the maturity.

“I tend to like four- or five-year investments. Right now, the market as a whole is overvalued. Too many assets are risky because they’re overpriced,” he said.

“A buffer, a longer maturity would be fine. But since we’re probably heading into a recession, I wouldn’t buy now at those levels.”

The notes are guaranteed by Goldman Sachs Group, Inc.

Goldman Sachs & Co. is the agent with JPMorgan as placement agent.

The notes are expected to settle on Oct. 17.

The Cusip number is 40056EAR9.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.