Scotiabank’s market-linked step-up autocalls on Russell offer yield, uncapped return

By Emma Trincal

New York, June 29 – Bank of Nova Scotia’s autocallable market-linked step-up notes due July 2025 linked to the Russell 2000 index provide a structure and tenor adapted to the uncertainty investors are facing amid the Covid-19 pandemic and the heightened risk of a recession, sources said.

The notes will be called at an annual call premium of 6% to 8% if the index closes at or above its initial level on any of the three annual observation dates beginning in August 2021, according to an FWP filing with the Securities and Exchange Commission. The exact call premium will be set at pricing.

If the index finishes above the step-up level – 135% of the initial level – the payout at maturity will be par of $10 plus the index gain.

If the index is unchanged or gains by up to the step-up level, the payout will be par plus the step-up payment of 35%.

Investors will lose 1% for each 1% decline beyond 15%.

Benefit of time

“I like it,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“Short-term, I would be cautious about small-caps. The outlook is not particularly encouraging.

“But on a five-year, you’re taking it out beyond the short-term arena,” he said.

All U.S. equity indexes have rebounded since their lows of three months ago. But the recovery of the small-capitalization equity benchmark has been a surprise for some.

“The surge in the Russell gives me a little bit of a pause,” he said.

Since its low of March 18, the index has regained 46% while the S&P 500 index (since its bottom of March 23) has recovered 39% of its value.

“Me and my partners are scratching our heads. Small-cap stocks have been hit harder by the lockdowns. There are not any rational metrics to justify such a run up. Our first instinct is: let’s watch this on the sidelines...it looks like a house of cards ready to fall apart.”

Small businesses have not been as resilient as large corporations during the pandemic. Now that coronavirus cases are rising in some states, leading some of them to roll back their reopening plans, fears of the economy shutting down again have resurfaced.

“If it was an 18-month note, I would take a pass. It would be too risky,” he said.

“But this market will recover within five years.

“So, I’m actually fine with the index given this timeframe.”

Credit

Kunhardt’s concern over the five-year term was more related to the issuer’s creditworthiness than to the performance of the underlier.

Bank of Nova Scotia carries an A- rating by S&P.

“It’s a pretty large bank, but it’s not like a JPMorgan or even a Royal Bank of Canada. I kind of would like to know what kind of reserves they have to cover their payments because at the end of the day, a structured product is an unsecured note. What happens if we get a worst-case scenario, something akin to 2008 or more economic shutdowns due to the pandemic?”

Structure

Overall, Kunhardt reaffirmed that he liked the note.

“It’s plain-vanilla. It’s not hard to understand. It would be pretty easy to explain,” he said.

“The 7% per year is well within the Mercer numbers. So, we’re fine with that,” he noted, in reference to Mercer’s projected equity returns, which his firm uses for its research.

“If you’re not called, you’re not capped. I do like uncapped returns.

“Plus, you get a 15% buffer, which is quite generous.

“To get a buffer, a digital and full upside exposure with no cap is a great way to enhance returns. I think it’s better than having leverage.”

Fulfilling a need

Matt Rosenberg, head of trading and strategic initiatives at Halo Investing, Inc., said those products are popular in today’s uncertain economic environment.

“People like those autocall step-ups. They provide a defined outcome with the call. And if the market is up significantly, you’re not missing out on the upside,” he said.

“This is a good mix of choices for people who are seeking a target return if the market is flat or retracing while trying to market time.

“Five years is a long way. You could see the market rise significantly. Investors want to be able to participate in a rally if there is one.

“In many people’s eyes, the Russell could be providing a bigger rebound over time than the Dow.”

A cheap option

The chances of getting one-to-one exposure at maturity means that the underlying price was negative a year prior to maturity on the fourth call date. For investors to earn more than the step level at maturity, the Russell 2000 would have to jump 35% or higher on that last year, a scenario that is possible but not necessarily likely.

“It’s a cheap option to price for the issuer. But it’s still benefits investors,” said Rosenberg.

“It might not be relevant. But it’s good to have it. It still gives you the benefit of an unlimited upside participation if there is a big run up toward the end.”

Scotia Capital (USA) Inc. is the agent.

The notes will price in July and settle in August.

© 2015 Prospect News.
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