TD Bank’s $1.41 million capped notes tied to MSCI EAFE introduce novel downside protection

By Emma Trincal

New York, Dec. 21 – Toronto-Dominion Bank’s $1.41 million of 0% capped index-linked notes due Jan. 11, 2023 linked to the MSCI EAFE index offer a geared buffer with a twist but advisers did not find that the terms were attractive enough to warrant the extra complexity.

If the index return is positive, the payout at maturity will be par plus the index gain, capped at 19.5%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is zero or negative but not below negative 20%, the payout will be par plus the return, up to a loss of 5%. If the index falls by more than 20%, investors will lose 1.1875% for each 1% loss of the index beyond 20%.

The upside is the equivalent of a direct exposure to the price return capped at nearly 20%, said Carl Kunhardt, wealth adviser at Quest Capital Management.

“This part is easy,” he said.

“But the downside is complicated. It would take a good 15 minutes to explain that to a client. It’s not necessarily the type of conversation I’d like to have with a client,” he said.

Two tiers

The downside can be divided into two tiers: the first tier –any decline of the index above negative 20% - is where the novelty resides. In that situation, instead of recouping their principal as would be the case with any buffer, investors will incur losses capped at 5%. Any decline of 5% or less will create a loss of the same amount. But from negative 5% to negative 20%, regardless of the index decline within this range, losses are all equal to negative 5% since the cap applies to these levels. For instance, a 10% decline would translate into only a 5% decline. Any 5% to 20% index drop would make investors lose a uniform 5%.

The part below negative 20% consists of a regular geared buffer. Investors only lose beyond the buffer, but this excess loss is multiplied by 1.1875, a figure calculated to bring the 80% possible decline beyond the 20% buffer down to 100% of principal lost.

For instance, a 21% index decline would only generate a 1.1875% loss.

“It’s a little odd, frankly, to be losing 5% if the index is down 20% and to lose only 1.18% if it’s down 21%, wouldn’t you say? How do you explain that to a client?” he said.

Unfit

Kunhardt would not consider the notes.

“It doesn’t fit into a particular strategy,” he said.

“Why are you using it? To hedge? Then use a straight buffer. I don’t have a market outlook telling me the market will be down between 5% and 20%, or I’m better if the index drops 21% than if it’s down 8%. That doesn’t feel right.”

The structure did not provide much on the upside, he added.

“It’s all about the downside. If you are that negative about the index, you shouldn’t be in equities in the first place,” he said.

“Heck knows the international markets should be up given how beaten up they’ve been.”

“When you get too wrapped up with so many moving parts, you stop losing sight of what you’re supposed to be doing, which is to make money.”

Cheaper put

Jerry Verseput, president of Veripax Wealth Management, said he understood why the issuer structured the buffer the way it did. But the result was still not appealing for investors.

“Instead of buying an at-the-money put at 100, they bought an out-of-the money put at 95,” he said.

The put gives its owner protection for any losses below the strike price. An “at-the-money” put protects against losses below the initial price. The term “at-the-money” refers to the price of the underlying when the option is bought, which is the equivalent of the initial price when the note starts trading.

Buying a 95 put, is to place the strike five points lower than the “at-the-money” price. Since the price is higher than the strike, the put is said to be “out-of-the-money.” It would be “in-the-money” (making money) if it was below the strike. Since the “out-of-the-money” put delivers less protection than an “at-the-money” put, its price will be cheaper.

“They just moved the strike price down a bit to 95 to buy the put a little bit cheaper,” said Verseput.

Complexity vs. benefits

Verseput was not concerned by the complexity of the structure.

“I could probably explain this in a YouTube video,” he said.

“It is a little bit more complicated. But the real issue is that you’re not getting much out of it.

The losses are capped at 5% but only in a “narrow range,” from negative 5% to negative 20%, he said.

“You beat the market a little bit but the complication of doing that doesn’t yield a great benefit.”

In addition, the note may be unbalanced with too much emphasis placed on powering the protection versus enhancing the return.

“With the vaccines over the next two years hopefully we should start to see some improvement. Europe should experience a recovery,” he said.

The MSCI EAFE index, which replicates the stock markets of developed countries, is overweight Europe.

“I want more upside than 19% personally. And I’m not getting that much downside protection.

“I understand that it’s all they can offer.

“But you’d be locking yourself up with terms that aren’t so great.

“I’d rather wait a couple of months. A market downturn should happen sooner than later.

“At that point, I would get much better pricing.

“Right now, the benefits aren’t sufficient to justify the complexity.”

© 2015 Prospect News.
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