TD Bank’s $8.9 million leveraged notes on Regional Banking ETF offer ‘legitimate’ bull play

By Emma Trincal

New York, April 14 – Toronto-Dominion Bank’s $8.9 million of 0% Accelerated Return Notes due June 28, 2024 linked to the SPDR S&P Regional Banking ETF may be a good pick for contrarian and bullish investors expecting the beaten-down fund to rebound, said Clemens Kownatzki, finance professor at Pepperdine University. But the terms used in the notes may not represent the best way to deploy that strategy.

The payout at maturity will be par of $10 plus triple any ETF gain, up to a maximum payout of par plus 33.2%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be exposed to any ETF decline.

“It’s obviously a riskier note than most given the full downside exposure. But it’s worth looking at the underlying first,” Kownatzki said.

Volatile fund

The SPDR S&P Regional Banking ETF has been under pressure since Silicon Valley Bank collapsed last month.

The ETF, which tracks the return of the S&P Regional Banks Select Industry index, includes among its top holdings First Republic Bank, Zions Bancorporation NA and PNC Financial Services Group Inc.

In that group, First Republic has been perceived as the next shoe to drop, facing deposit outflows and intense selling pressure.

The ETF, however, has 144 components whose business models are in no way identical to SVB’s, said Kownatzki. As a result, the regional bank ETF may offer a unique opportunity for value investors, arguing that the fear of further contagion may be overdone.

Silicon Valley Bank

“What happened to Silicon Valley bank is intriguing. They mishandled interest rate risk. There was an asset-liabilities mismatch. They lost money. People pulled out. That’s how they went under,” he said.

“It’s puzzling when you think that managing interest rate risk is the go-to for the banking business. Banks borrow short-term and lend long-term. If interest rates go up, your long-term bonds are going to lose value. Everyone knows that. That they weren’t able to hedge that risk is mind-boggling,” he said.

The failure is all the more surprising given how the Federal Reserve “telegraphed” its tightening cycle.

“Perhaps many underestimated the speed at which the Fed raised the rates,” he said.

Another characteristic distinguishing SVB from its peers was its client base.

“SVB was not as diversified as most regional banks. The majority of its depositors were tech startups and venture-capital firms. It was a risky proposition,” he said.

“Very few banks do that.

“Imagine a bank only doing business with farmers. Comes a flood. Everyone needs money at the same time, and you have a bank run. Hopefully, farmers’ banks hedge that risk. But apparently, SVB did not hedge its duration risk.”

Contrarian view

The bank collapse led to a widespread panic in the sector.

“The market over-reacted, I think. People moved their money from community banks into big banks.

“Now the entire financial sector is under stress including the brokerage industry. Even big banks have been punished,” he said.

The scary headlines around SVB put regional banks under disproportionate pressure with the ETF shedding more than a third of its value since February when the share price hit a year-to-date high.

“There is still a lot of uncertainty in the space, but things have come down a bit. Aside from some other calamity – a major recession for instance – I can see how regional banks may offer a legitimate bullish play,” he said.

“If you have a little bit of a contrarian mindset, it makes sense.”

Options alternatives

The 33.2% cap gives investors a maximum annualized compounded return of nearly 28%.

Kownatzki looked at the heavily discounted entry price of $42.63 on the trade date.

“That’s 38% off the one-year high. There is definitely potential for upside. I would probably deploy a different bullish strategy,” he said.

One possibility would be to purchase the ETF outright. Replicating the three-times upside exposure could be achieved through margin.

A preferred strategy would be to buy call options on the ETF.

“I could buy several calls in order to get my leverage. It wouldn’t cap my return.

“Also, my downside would be protected as I’m long the calls.”

Options buyers cannot lose more than the premium they paid.

“I like the idea that potentially the price could move up a lot. I’m aligned with this thinking that the market is probably over-reacting.

“But I would not do this trade with a cap on the upside without hedging my downside.

“So, while I like the concept, I would not use the notes. I would play my bullish sentiment differently.”

BofA Securities, Inc. is the agent.

The notes settled on Friday.

The Cusip number is 89116C750.

The fee is 1.75%.

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