GS Finance’s bearish barrier early redeemable notes on the S&P to offer limited hedge

By Emma Trincal

New York, May 22 – GS Finance Corp.’s 0% bearish barrier early redeemable market-linked notes with daily barrier observation linked to the S&P 500 index offer investors full principal-protection over a short period of time – a tenor comprised between 19 and 20 months, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are designed for bearish investors expecting the index to drop by less than 25% at maturity without ever falling further on any trading day. But sources said a most likely use may be as a hedge.

Early redemption

One feature is the possible early redemption: if the barrier is breached on any day during the life of the notes, the notes will be automatically redeemed at par plus 1%, according to the filing. This outcome may be favorable if the barrier knocks out early on.

If the notes are not automatically redeemed, the index will either finish positive or negative by less than 25%.

In the first scenario, which is bullish, investors will only get par plus 1% at maturity. The best outcome is the second set-up, in which the index finishes down and above the 75% barrier. In that case, the payout will be par plus the absolute value of the index decline.

American barrier

A market participant elaborated on the impact of the barrier type.

“You’re really threading this needle,” he said.

“The American barrier on this increases the odds that you will knock out and get only 1%.

“Are you buying this to make 1% or to hedge the rest of your portfolio?”

He offered the example of the index never dropping more than 25% and finishing down 10% or 20%.

“That works as a hedge. You’re not doing this note as a directional bet on the downside. You’re doing it to hedge your exposure. And it that case it works great,” he said.

Imperfect hedge

But he questioned whether this outcome had a high chance of happening.

“If it knocks out you didn’t hedge anything against losses in other parts of your portfolio.

“I’d rather have a European barrier. But of course, a European barrier on the downside won’t price out. It will blow up the whole trade,” he said.

A European barrier is by definition observed point-to-point rather than on multiple data points. European barriers, which are the basis for almost all barrier protections in structured notes are more expensive since the chances of a knock out are much lower, he explained.

“That’s why they can offer the full protection on this short tenor. The option for that barrier is inexpensive. But there is no free lunch. You’re buying some kind of contingent insurance, which has a high likelihood of not paying off.

“Your hedge could be extinguished when you most need it...and that is when the market is down significantly.

“It’s far cheaper than buying a put option. But you get what you’re paying for.”

Upper, lower barriers

Those structures sometimes called “shark notes” for the fin-like shape of the payoff diagram illustrating the drop in the payoff from participation to a lower bonus, have regained traction. Many such deals were issued in last year’s fourth quarter and earlier this year, but the flow has slowed in recent months, according to data compiled by Prospect News.

The majority of those deals in the past were based as non-directional plays. They included an upper barrier in addition to the lower barrier, giving investors positive participation as long as the underlying stayed “in the range,” confined between the two barriers at any time.

Volatility bet

“It’s just like a straddle. It’s going in one direction. You’re not sure which way,” said an industry source, commenting on the dual-directional version of the structure.

“I’m not crazy about it. They tend to be so restrictive. The probability that you’re going to get back only a 1% or 2% bonus plus principal are so high, it’s not worth it.

“If something goes in your favor, that would be a windfall. But the odds aren’t there.”

Owning the index fund outright was a preferable option, one “that’s not as random,” in his view.

“Here is the thing: If you can’t predict which way it’s going to go, how can you predict how far it’s going to go?

“You invest in those kinds of straddle but you’re locking in small returns.”

Ultimately buyers of the notes are betting on volatility remaining flat.

“People buy straddles all the time. I just don’t like the odds for those products.”

The maturity date will be three business days after the determination date, which is expected to fall between Dec. 29, 2020 and Feb. 26, 2021 and will be set at pricing.

Goldman Sachs & Co. LLC is the underwriter. UBS Financial Services Inc. is acting as selling agent.

The notes will price on May 29.

The Cusip number is 40056FJF3.

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