Yen exposure lacking with TD Bank’s $8.4 million capped notes on Topix, contrarian says

By Emma Trincal

New York, March 18 – Toronto-Dominion Bank’s $8.4 million of 0% capped index-linked notes due March 12, 2027 tied to the Topix index provide attractive terms for a bullish bet on Japanese stocks, but investors would have been better off with exposure to the Japanese yen as well, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

If the index return is positive, the payout at maturity will be par plus the index gain, subject to a maximum return of par plus 85.5%.

Otherwise, the payout will be par, according to a 424B2 filing with the Securities and Exchange Commission.

No bet on the yen

“This 100% protection is unusual. I think it’s a very useful feature. You don’t get the dividend but at least you are guaranteed to receive your principal back,” said Kaplan.

“The only thing is the Japanese yen. The yen is very low. It should appreciate against the U.S. dollar and it doesn’t look like the note allows you to bet on the currency.

“It’s hard for me to even consider investing in Japanese stocks without taking advantage of the exchange rate.”

He offered a hypothetical example: if the Topix index rises 30% and the yen appreciates against the dollar by 30%, investors’ total return would be 60%.

The structured note is currency neutral. Investors will not benefit or lose from exchange rate fluctuations between the U.S. dollar and the Japanese yen.

“To me that’s an issue. If the yen goes up, you’re leaving a lot of return on the table.

“You may win just as much on the currency conversion than on the equity position itself,” he said.

Quanto

When investors buy notes tied to a foreign equity exchange-traded fund, the shares are converted in U.S. dollars, giving noteholders exposure to currency risk. If the dollar strengthens against the foreign currency, investors are negatively impacted by the conversion because the foreign currency will buy fewer dollars, making the position worth less in dollars. But if the foreign currency appreciates against the dollar, the conversion provides more dollars and therefore, more gains to the U.S. investor.

On the other hand, when the underlying is a foreign index (as is the case with this note), the currency exposure is usually hedged by a quanto option. Risk and return potential, which derive from exchange rate moves, are therefore removed from the equation.

Low yen

“There are a lot of gains you can have from the strengthening of the yen against the dollar,” he said.

Kaplan said he is long the Invesco CurrencyShares Japanese Yen Trust, which tracks the Japanese yen.

“The yen is extremely weak right now,” he said.

A U.S. dollar a year ago was worth ¥108.901. Today, the rate is ¥119.20, a nearly 10% increase.

The chart of the Invesco Yen ETF showed the currency is at its lowest level since December 2015.

“Sophisticated investors are now buying the yen. It’s undervalued,” he said.

As a contrarian, Kaplan believes that oil prices are likely to decrease, which would be beneficial for Japan, a country highly dependent on crude oil imports. Such scenario would also be bullish for the yen, he said.

If the yen appreciates as Kaplan expects, currency gains will not be reflected in the return of the notes.

“The exchange rate can have a real impact on your return. You’re certainly adding risk. But it makes no sense to remove this leg of the trade,” he said.

The portfolio manager said that most retail investors want to buy stocks without incurring currency exposure.

“I can understand that. But I don’t see it that way, especially when it comes to Japan and the Japanese yen. The note is fine. But not getting the currency exposure would keep me from doing it,” he said.

Lukewarm Topix

Kaplan is hardly as bullish on the Topix as he is on the yen.

“The Topix index has posted a few rallies if you look back over a long-term chart, like the last 30 years,” he said.

But overall, the index’s performance has been subdued after the burst of the Japanese bubble in 1992, a period called the “lost decade.”

“The Japanese stock market is not as volatile as the U.S. market,” he said.

“There is no craze around Japan. It’s not a very exciting market so people look elsewhere. They always want to jump on what’s hot. People chase returns. They go for the momentum, which is why the U.S. market is overvalued.”

Even insiders have not shown sustained enthusiasm for Japanese equity, buying scarcely as good bargains were hard to find, he noted.

“There have been points when insiders have been buying – times when the market was deeply depressed like in 2002, 2003 or the end of 2008. But right now, nothing is even close of being below fair value.”

Terms

The full downside protection of the notes may help as global markets are entering a bear market, he said.

“Japanese stocks are not as overpriced as U.S. stocks. But as we’re getting deeper in a bear market, every market in the world is going to be impacted,” he said.

The five-year tenor may allow the index to recover some or all of its losses, he said.

“In case the Topix doesn’t go back to its initial level, at least you have the downside protection,” he said.

While investors run the risk of earning meager returns depending on how severe and lengthy the bear market may be, the cap was high enough to make the note attractive for investors seeking exposure to this market.

“My only real objection here is that you’re only playing the equity market. A successful play on Japan right now requires to add the currency exposure, which will translate into sizable gains if the yen appreciates as I think it will,” he said.

TD Securities (USA) LLC is the agent.

The notes settled on Thursday.

The Cusip number is 89114V6L6.

The fee is 4.33%.

© 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.