Scotiabank's buffered digital product tied to MSCI EAFE puzzle buysiders for its cap, maturity

By Emma Trincal

New York, July 9 - Bank of Nova Scotia's buffered participation notes with digital coupon linked to the MSCI EAFE index offer a chance of outperforming the underlying international equity benchmark as well as a strong credit, but several buysiders were perplexed by the risk/reward profile of the note as well as its unusual duration.

The maturity date will be five business days after the valuation date, and the valuation date will fall 39 to 45 weeks after pricing, according to a Suppl filing with the Securities an Exchange Commission. At the midpoint of the range, the tenor is about 10 months.

If the final index level is at least 90% of the initial index level, the payout at maturity will be par plus the digital coupon, which is expected to be 4.6% to 5.4%. Assuming the midpoint, the coupon would be 5%.

The exact maturity date and digital coupon will be set at pricing.

On the downside, any final index level less than 90% of the initial level will generate a loss of 1.1111% for every 1% that the index declines below the buffer. As a result, investors in theory may lose their entire principal, according to the prospectus.

Low cap

Buysiders said that despite the short tenor and the 10% buffer, the digital payout is probably not high enough for the risk incurred given the underlying index.

"I would never invest in that," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"It's an excellent credit. The underlying index doesn't bother me. That's one of the major indexes we use. We benchmark our international stocks to it.

"But that 10% buffer with a 5% cap! Come on! That's an index that could be up or down 10% in one day. I realize that it doesn't matter what happens in one day and that it's point to point. But Europe is a large portion of the underlying benchmark. It could be down 50% in one year. For something as volatile as that, I would want to see a greater buffer, especially if I give up my upside."

The underlying index tracks the equity performance of developed market countries, excluding the United States and Canada. It consists of companies from 22 developed countries, with the top weights in the United Kingdom (23.35%) and Japan (21.72%).

Stocks in the greater Europe region represent about two-thirds of the index and the euro zone countries nearly a third.

"Five percent return is bond territory. Why would I take full equity risk to take a bond return?" Kunhardt added.

A financial adviser held the same view.

"I don't know who would want a 5% cap with a potentially unlimited downside. It's not enough. It's silly."

Despite the 10% buffer, the negative leverage factor of 1.11 makes it possible for investors to end up losing their entire principal at maturity, according to the prospectus.

European exposure

Overall, the use of the MSCI EAFE index as the underlying was not the main culprit in the buysiders' negative assessment of the product. Rather they criticized the terms, saying that the upside or the protection were too limited, depending on their view.

"We have a globally diversified equity portfolio and have representation in those EAFE markets," the financial adviser said.

"Europe sells at a 30% discount to the U.S. so you're compensated for the risk.

"If you look at the European stocks in the index, these are big companies that do business globally. The home office happens to be in a bad zip code. But you're talking about Total, Sanofi, Siemens. These are great companies."

The adviser said that he would not recommend the notes to a bullish investor.

"If you thought Europe was going to fall only by 10%, you should go long," he said.

"The view is positive to slightly negative. But Europe could rally and recover to 11%. All you need is to get the European Union half right."

Irrational rationale

A hedge fund manager who invests in structured products said that the rationale behind the notes was somewhat puzzling.

"You might as well buy the index," he said.

"If you believe we're coming to the trough period in Europe, it makes no sense to put a cap on it. If you think there's more downside risk, then you should avoid it entirely."

Instead, investors should look at alternatives that enable them to "get paid to wait," this manager said.

"To me, a better trade is go long U.S. equity, short Europe.

"But if you want to get long exposure to developed countries and Europe, you could get paid to wait and create a synthetic option.

"Or you could get exposure to a high-dividend or a low-volatility fund and get paid to wait too," he said.

As an example of this strategy, he recommended buying the SPDR S&P International Dividend exchange-traded fund with its 7.76% yield.

Among the low-volatility funds that also pay high dividends, he suggested the PowerShares S&P 500 Low Volatility Portfolio ETF, the PowerShares S&P International Developed Low Volatility Portfolio ETF and the PowerShares S&P Emerging Markets Low Volatility Portfolio ETF.

"I think Europe will continue to have issues and unravel, so getting paid to wait is the best way to do it," he said.

Capital gains

Buysiders also found it unusual that an issuer would offer a note with a term of 10 or 11 months. Under a one-year term, any gain gets taxed at the higher short-term capital gains tax.

"The 11-month maturity doesn't really make sense to me," the financial adviser said.

But a market source said that the deal was not designed for wide distribution, which might explain some of its oddities.

"I believe the strategy is reverse-inquiry in nature and the short-dated terms are at the request of the dedicated investor group," a market participant said.

Top credit

"The best of this offering is that it's got a good credit," the hedge fund manager conceded.

The issuer's creditworthiness is important in today's market even if this is a short-term product, the market participant said.

"Scotia is the best credit in the structured products business right now. Some of Scotia's rivals, such as RBC, have just been downgraded by Moody's," the market participant said.

An investment adviser said that the payout would work for someone who has a range-bound view on the index.

"I guess if you assume there is a fairly narrow band with the bias slightly downward, that could be the type of note for that. But it's a tough one. It's a fairly neutral view.

"As you know, this index has been pretty badly beaten up with the backdrop of all the European issues. Will it go down further or will it rally? It's hard to make a call on this one," he said.

A spokesman at Scotiabank did not return calls seeking comments.

The notes are expected to price Tuesday and settle July 17.

Scotia Capital (USA) Inc. is the underwriter, and Goldman Sachs & Co. is dealer.

The Cusip number is 064159833.

© 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.