Scotiabank’s step-up notes linked to index basket help timing entry into toppish world markets

By Emma Trincal

New York, Oct. 23 – Bank of Nova Scotia’s 0% market-linked step-up notes due October 2019 linked to an international equity basket provide a simple way to make money for investors unwilling to call the top of the bullish trend in some of the best-performing regions of the world – regardless of the pace of the rally, which facilitates the decision to get in when valuations are rich, sources said.

The basket consists of the Euro Stoxx 50 index with a 60% weight, the MSCI Emerging Markets index with a 20% weight and the JPX-Nikkei Index 400 with a 20% weight, according to an FWP filing with the Securities and Exchange Commission.

If the final basket level is greater than or equal to the step-up value, 118% to 124% of the initial value, the payout at maturity will be par of $10 plus the basket return.

If the final basket level is greater than or equal to the initial level but less than the step-up value, the payout will be par plus the 18% to 24% step-up payment.

Investors will lose 1% for every 1% basket decline.

BofA Merrill Lynch is the agent.

Concentrated version

These indexes have appeared together in baskets many times before, but for the most part those baskets included other benchmarks, such as the FTSE 100 index, the S&P/ASX 200 index and the Swiss Market index, according to data compiled by Prospect News. Very often it is the Topix index that is used for the Japanese equity exposure rather than the Nikkei.

The majority of the notes linked to this type of underlying basket before have used leveraged capped structures rather than this type of uncapped digital payout, the data showed.

Minimum gain

“I really like this note because it gives you ‘your cake and eat it too,’ so long as you like the underlying,” said Steven Foldes, vice-chairman at Evensky & Katz/Foldes Financial Wealth Management.

One of the most obvious attractive features is the step-up, as it can boost the return in a sluggish market.

“The important thing is this digital. If this blended basket is even flat, you’ll get a nice return,” he said.

“Since that particularly compelling 60-20-20 basket had such a strong year, you’re at least guaranteed to get a 10% return, which will make up for the loss of dividends.”

The weighted average dividend of the basket is 2%.

“In [a] less bullish market, you’ll get this 10% a year, a magic number if the performance remains flat or only slightly positive.”

Uncapped

Usually digital returns will cap the upside, and this note does not, he noted.

“What I really like about this is the idea of a no cap. If the three international indices continue to do well, and let’s hope they do, you continue to participate. You’re not hurt by a cap. You get the full amount of the upside minus what you lose in dividends.”

Foldes said he customized with JPMorgan a similar “digital jump” on the emerging markets about a year and a half ago. The underlying performance has been good, in fact higher than the digital amount, he noted, allowing his clients not to miss on the rally. The notes are slated to mature in 90 days.

He uses these types of structures – digital and then one-to-one upside – in his portfolio because they yield benefits in any kind of up-trending market.

“Obviously it’s not a note for the downside protection. You have to believe in the asset class. We do. We think that the weightings in this basket – 60%, 20% and 20% for Europe, emerging markets and Japan – are the way to go if you want ex-U.S. exposure. The structure combining the digital and the uncapped participation is going to achieve terrific results.”

Toppish world markets

Paul Weisbruch, vice president of ETF/options sales and trading at Street One Financial, said that given current market valuations for the three underlying indexes, the notes could benefit investors if the trend begins to be less bullish.

“It’s fair to say that the U.S. is at or near all-time highs. Emerging markets are not far from their all-time highs. As far as Japan, we’re right now at the 52-week high. ... All three segments of the international equity market are at or near all-time highs,” he said.

The Nikkei 225 rose 1.1% on Monday after Prime Minister Shinzo Abe’s ruling coalition won the elections on Sunday. The benchmark is up more than 26% for the year.

Most of the major international indexes are up for the year as well.

Unknown peak

“It would be reasonable to say that these indexes in the basket are only going to be up a little because of the run we had,” he said.

“You could make the argument that getting much higher will be tough.

“Besides not getting dividends, I don’t see a lot of downside in this deal.

“It’s a fair game to accept if you’re comparing this with getting into the market or the ETF without any hedge.

“It’s appealing in the sense that you don’t have to have further upside to benefit from this trade. You can gain from a modest return.”

On the downside, investors are “in lockstep” with the basket itself.

“If they go down, you go down. You’re not worst of.”

Weisbruch said the payout on the upside is particularly timely as every market participant right now is asking himself the same question: Will the bull market continue to push higher, or will we see a correction?

“I hear it all the time: the market is overextended. But every time we speak, the market is higher than last time we spoke,” he said.

“There are bears out there, clearly. But I’m not going to say this is the top. If you invest in something when you just don’t know if there’s more upside or if it’s going to go sideways, I’m not outright losing with this note. I don’t have to get short to make money.”

The notes are expected to price in October and settle in November.

© 2015 Prospect News.
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