Scotia’s $2.55 million Buffered PLUS on iShares Silver seen as not ‘defensive’ enough

By Emma Trincal

New York, Nov. 10 – Bank of Nova Scotia’s $2.55 million of 0% Buffered PLUS due Nov. 4, 2026 linked to the iShares Silver Trust provide an attractive upside return, but the buffer is probably too small given the volatility of the underlying commodity and risks associated with the asset class, said Clemens Kownatzki, finance professor at Pepperdine University.

If the return of the ETF is positive, the payout at maturity will be par plus 300% of the gain subject to a maximum return of par plus 53%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the ETF declines by 15% or less and will lose 1% for every 1% that it declines beyond 15%.

False premise

Kownatzki first debunked the “myth” around the benefit of silver as an inflation hedge. The value of the notes should not rely on such expectation, he said.

“It’s a commonly held belief that gold and silver are hedges against inflation. But it’s completely wrong,” he said.

“If you look at historical data for inflation-adjusted silver prices per ounce in the past 100 years, you’ll see that prices have collapsed.”

“The inflation-adjusted price of silver in 1981 was $141 an ounce. At pricing, the ETF closed at $21. Clearly, silver doesn’t really offer a reliable protection against inflation.”

He reiterated the point going back closer in time.

“When inflation started to kick in in 2021 and 2022, silver prices dropped.”

Fair pricing

The three-year note with a leverage multiple of 3 and a cap of 53% generates an annualized compounded return of 15.23%, which can be achieved with a 5.57% annual increase in the ETF price.

Kownatzki established that the notes were adequately priced using forward pricing formula.

“If the spot price is $21, assuming a risk-free rate of 5% and a storage cost of 0.4% per annum, if I calculate the forward value for a three-year timeframe, I get a fair value forward price of 24.66%. That’s an annualized gain from the spot price of 5.55%. Pricing is right. It’s always right,” he said.

Rationale

What silver provides is not an inflation hedge, but a diversification tool, he noted.

“That’s the role of most commodities. If you have a portfolio of bonds and equities, some commodities can add some good diversification. I don’t question this argument,” he said.

Diversification, he argued, was probably the right reason to buy a note linked to this asset.

Tight buffer

Kownatzki proceeded to look at the risk-adjusted return of the notes.

“The cap of 15% a year seems attractive. But I’m not sure that the 15% buffer would hold over three years,” he said.

He noted that the three-year implied volatility of the iShares Silver Trust was about 30%, which is approximately twice that of the S&P 500 index.

“I did a quick calculation over a three-year timeframe. There is roughly a 60% probability that the price would finish above that buffer. In other words, there’s a 40% chance to see the price fall below the buffer after three years. That’s a lot. I wouldn’t be comfortable with that risk,” he said.

“Now this is just today’s perception. A number of things can happen in three years. The price could double. Who knows?”

It more than doubled during the pandemic year in 2020. In early 2021, retail investors influenced by social media short-squeezed silver, bidding up the share price of the ETF.

But Kownatzki did not expect a similar bull run looking forward. His view was less optimistic.

“While there’s a higher chance the price will be above the buffer, I’m concerned about the level of protection. 15% may be too tight,” he said.

Contango

Another risk factor was the cost of rolling the underlying futures contracts of the ETF, which tracks the price of silver bullion.

“With the market in slight contango, the rolling may be negative,” he said.

A futures market is in contango when current contract prices are lower than futures prices, which makes the cost of rolling the contracts at expiration more expensive.

The contango trend would worsen if interest rates were to rise further, he said.

When interest rates rise in a contango market, the cost of carry increases, which in turn drives up the price of longer-dated contracts. As a result, the spread between spot and futures prices will widen, which generates what is known as a negative roll yield, he explained.

“Put simply, there is a cost of rolling the futures contracts. If the cost goes up, it will erode the performance of the ETF,” he said.

Headwinds

Geopolitics as well as politics represented additional risk factors.

Kownatzki pointed to the obvious geopolitical risks with the wars in Ukraine and in the Middle East.

“But we also have political uncertainty with the Elections next year. How will the result affect interest rates is anyone’s guess. Inflation and government spending are key factors in the price of commodities. While silver is not in my opinion an efficient hedge against inflation, inflation does have an impact on its price.”

In conclusion Kownatzki said the notes were not sufficiently defensive.

“There is a lot of uncertainty ahead of us. Silver is a very volatile underlying. The 15% buffer is too tight.

“While the upside is attractive, the risk is simply too high,” he said.

Scotia Capital (USA) Inc. is the agent. Morgan Stanley Wealth Management is distributor.

The notes settled on Nov. 3.

The Cusip number is 06417YWH8.

The fee is 3%.

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