Scotia’s $3.4 million bear Accelerated Return Notes on S&P 500 to offer possible hedge

By Emma Trincal

New York, Nov. 1 – Bank of Nova Scotia’s $3.4 million of 0% bear Accelerated Return Notes due Dec. 20, 2019 linked to the S&P 500 index caught some market participants’ attention as they rarely see those products even in choppy markets. Yet their use could help investors protect their portfolio although the hedge is not perfect, a trader said.

If the index return is negative, the payout at maturity will be par of $10 plus 3% for every 1% that the index declines, subject to a maximum return of 30.18%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is positive, investors will lose 1% for every 1% that the index increases.

Infrequent

“We should be seeing more bear notes because now is a good time to be cautious in the market. But bear notes are very rare, especially on the retail side,” an industry source said.

“In the last 20 years I’ve seen some from time to time. But they are not very popular.”

Yet those structured products are easier to manage compared to options or short-selling, he argued.

“It’s easier for an investor to buy a $1,000 bear note than a put. It’s a small exposure. You don’t need to open an option-holding account. But it may not be cheaper.”

Tactical bet

Buying the notes requires having a bearish view on the market as investors are penalized if the market rises instead of falling.

“It’s tactical in nature. It’s not for everyone,” a market participant said.

“If you’re bearish and that’s your market outlook, it’s a good note.”

He pointed to the “compelling” terms on the note, especially for the “upside,” which brings a positive return worth three-times the index decline up to a 30% cap.

“The same terms on a bullish note would not price as well. You wouldn’t get 3x up with a 30% cap on the upside, especially not on a 14-month,” he said.

More for traders

Despite the pricing, this market participant agreed: bear notes are not popular among individual investors.

“They don’t sell easily. People are interested though. It’s always a conversation topic. But it’s not suited for everybody. It’s more of a trading product, something you might want to use as a hedge,” he said.

“In my experience I found that people who are somewhat neutral or slightly bearish would rather buy an autocall than a bear note. It gives them a more definite outcome.”

Clemens Kownatzki, independent currency and options trader, said he was unsure whether the note should be considered a hedge.

“If you’re bearish and the index is down, your cap is 30%. That means you don’t expect the market to drop more than 10%. If it does you’re capped out,” he said.

“You’re bearish but you’re really making the assumption that we won’t have more than a correction.”

He conceded however that getting a 30% positive return made the investment very desirable regardless of the amount of decline, including in a severe bear market.

“You’re generating alpha,” he said.

Rally problem

The notes were not designed for neutral or bullish investors. Any increase in the index would cause investors to lose money on a one-to-one basis, he said.

“It’s a directional bet. You have to be a bear,” he added.

“If the S&P rallies, you’re robbing yourself of the opportunity of taking advantage of that upside.

“That’s one of my problems with that and that’s what makes me hesitate to call it a hedge. You have a view. But you’re not protected if you’re wrong.”

This may be true of many investments: most are unhedged.

If investors want to use the note as a hedge, there are pros and cons, he reasoned.

“In theory it’s not a pure hedge. In practice, 30% is enough to make a lot of investors happy in a bear market,” he said.

Good enough

He offered the following example.

An investor owns a hypothetical 100 of the S&P 500 index and wants to protect his portfolio with the notes.

If the index drops 50%, with the notes, the investor will receive a 30% profit, which is the cap. Effectively, the long position would be covered up to 30% but the value of the portfolio would still be down 20% from 100 to 80.

“It’s not a perfect hedge. You’re not neutral. It matters if the index is up or down,” he said.

“But to be fair, it’s an extreme example of a bear market. While the hedge is no longer working after 30%, it’s still pretty good. I think most people would be pretty glad with the outcome.”

Long put

As an alternative, Kownatzki would buy an out-of-the money put, which means that the strike price would be below the initial level of the index. The position loses money if, when the contract expires, the index closes above the strike. If it doesn’t, the now “in-the-money” option would produce a one-to-one gain from the strike level.

“Granted buying options is expensive, but at least I know what I’m getting into.”

The notes (Cusip: 06417P777) priced on Oct. 25.

BofA Merrill Lynch is the agent.

The fee is 2%.

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