Scotiabank's leveraged buffered notes tied to MSCI EAFE are for bullish yet cautious investors

By Emma Trincal

New York, June 28 - Bank of Nova Scotia's 0% series A capped buffered participation notes linked to the MSCI EAFE index are designed for bullish investors who still need to control risk, which leads to a structure that is less risky than the average leveraged note yet one that may meet bullish expectations, said Suzi Hampson, structured products analyst at Future Value Consultants.

However, the scoring is far from final: two key terms - the cap and the tenor - are defined in a range, so the return and price scores of the product could change when the final terms are set at pricing, she added.

The notes are expected to mature 24 to 27 months after pricing, according to a 424B5 filing with the Securities and Exchange Commission.

If the final index level is greater than the initial level, the payout at maturity will be par plus 150% of the index return, subject to a 22.12% to 25.87% cap.

Investors will receive par if the index falls by up to 10% and will lose 1.1111% for every 1% decline beyond the 10% buffer.

Ranges

"The cap and the maturity are not specified other than in a range, which makes a difference. It's a pretty vague product so far," Hampson said.

"I'm surprised that those uncertain terms do not put people off. It must not bother U.S. investors. You don't have this at all in the U.K. They all price six weeks before the strike.

"They may have to hedge it, which could add a cost that they may pass on to the investor as they have to get paid for taking on that risk. Or they may close the trade if pricing moves too far. But the terms are all set four to eight weeks before pricing. Not in the U.S.

"Even still. Sometimes with U.S. deals, you get a range on the cap. Most people do that. But here, they do a range on two terms, not just the cap but also the maturity. It leads to quite a lot of uncertainty, especially when you try to score the product."

Future Value Consultants rates the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

The product has a 2.39 riskmap. The average riskmap for deals of the same product type is 3.40, and the average riskmap for all products is 3.93.

Risk components

The credit risk component of the riskmap, at 0.71, is higher that the average leveraged products credit riskmap, which is 0.65, according to Future Value Consultants' report.

"It's higher and it's due to the maturity. Most leveraged products are one year to 18 months. It's certainly not attributable to the issuer. This bank has a low credit risk. It's more of a maturity thing," she said.

Hampson explained that the credit risk increases with the maturity.

"If you had this issuer on a one-year maturity, your credit riskmap would be lower," she said.

"But an investor may be satisfied with the extended maturity if he's comfortable with the issuer's credit.

"The credit score is meant to give investors an assessment of the risk and help them compare products based on criteria such as creditworthiness and duration.

"Ultimately, it's the individual investor who will make the final decision based on his own risk reward expectations."

Unlike the credit riskmap, the market riskmap is lower than average. The notes have a 1.68 market riskmap, compared with an average riskmap of 2.75 for comparable products.

"The 10% buffer reduces the risk obviously. In addition, we have an underlying that's not excessively volatile. With an implied volatility of 22%, the EAFE index is more volatile than the S&P 500, which has an implied [volatility] of 18%, but it's still presumably lower than some other funds that we see some of these products linked to," she said.

Return score

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios, which with this product is bullish.

The notes offer a 7.40 return score, compared with 7.52 for the same product category. The average return score for all products is 6.67.

"The return score is slightly below the average for all products but similar to the average of the same product type, which shows that for the amount of risk you're taking, your return is comparable to similar investments," she said.

"Investors choosing this type of leveraged note are looking for a lower-risk product. The return score is quite fair."

However, Hampson stressed how important it is for investors to take into account the variability of some of the terms in the announced product.

"We do have a variable cap and a variable maturity. Again, from a rating standpoint, that's a lot of variables," she said.

"We try to measure the key metrics of a product through various scores in order to facilitate comparisons between products. But with these unknown factors, our score could vary a lot. If the issuer decides to pick a longer maturity with a lower cap, obviously, the return score will get lower. On the other hand, we could get a higher score if they shortened the term and raised the cap. It really depends on the final terms."

Cautious bull

"The notes may appeal to pretty bullish investors who are still cautious about market risk," she said.

"You find these two aspects of the investor's profile in the relatively high cap combined with the buffer.

"A lot of the leveraged return deals that we see have a higher participation of two or three times. This one with 1.5 times the growth is lower, which means that it has a higher cap than the higher-gearing products that we see.

"We're dealing with a more bullish profile than some of the other leveraged notes. The higher gearing would be paid with less return potential. So this product clearly is going for the more bullish investor.

"Also bullish in this structure is the longer maturity. A longer time to maturity will give you more time to grow."

Interesting combo

In order to benefit from the relatively high cap and buffer, investors have to accept a trade-off, she said.

In order to price the relatively high cap and the 10% buffer, the issuer had to extend the maturity compared to the average for this product type, she said. In addition, the leverage factor probably had to be reduced compared to the average leveraged note, she noted.

"By extending the maturity and lowering the gearing, the issuer was able to raise the cap while still including a buffer. That's the trade-off. It requires being more bullish than other types of investors who would prefer more leverage in order to satisfy their lower growth expectations," she said.

"This product offers the characteristic of being more bullish than other similar products while slightly less risky. That is an interesting combination. The typical investor has strong bullish convictions, but it doesn't necessarily mean that they are going to take market risk lightly."

Price score

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

At 8.13, the product has a better price score than the average of its peers, which is 7.67, the report showed.

"This score is the most sensitive to the variable terms. We picked favorable terms with a 25% cap and a 24-month maturity. By using the shorter end to the duration range and a higher cap, it's not surprising that we would get a pretty good price score. In itself, the score suggests that the issuer spent a good amount of money on the options. If the terms were to be less favorable, however, the conclusions would differ quite a bit and the price score would be revised downward," she said.

Overall score

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

The notes have a 7.77 overall score, compared with an average overall score of 6.71 for all products.

"The overall score is higher than all products because both price and return scores are higher.

"This score offers some guidance rather than a final analysis of the product, which makes scoring difficult. But at least it gives an indication that there is nothing fundamentally wrong with the product. The risk is good. The return is average. The price is good.

"As long as they don't move too far away from our assumptions, the notes should score quite well on pricing date," she said.

The notes (Cusip: 064159452) are expected to price Monday and settle July 9.

Scotia Capital (USA) Inc. is the underwriter with Goldman Sachs & Co. as dealer.

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