CIBC’s 9% STEP Income tied to D.R. Horton offer equity-like return for risk-tolerant investors

By Emma Trincal

New York, July 11 – Canadian Imperial Bank of Commerce’s 9% STEP Income Securities due August 2019 linked to D.R. Horton, Inc. common shares target investors seeking above average income who expect the volatility of the stock to stay low. As long as the underlying share price does not fall at maturity, the coupon paid will be an equity-like return.

Interest will be payable quarterly.

If the price of D.R. Horton shares finish at or above the step level – 109% of the initial price – the payout at maturity will be par of $10 plus a step payment of 1% to 5% that will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the stock finishes at or above the initial level but below the step level, the payout at maturity will be par.

Investors will lose 1% for each 1% decline.

Step income

“This is a kind of reverse convertible. It has the fixed rate plus an additional coupon if you’re above the threshold,” a market participant said.

“Typically, you get upside participation above the 109% level. Here they’re giving you another coupon above the fixed rate if the stock is above 109.”

From 1% to 5%

That additional payout or step payment will be within a wide range to be set at pricing. This did not shock the market participant, who said the agent is showing the deal now before the trade date in a couple of weeks.

“It’s a way to keep it open. If between now and pricing, volatility contracts, it will be in the lower end of the range. If volatility expands, it will be a little bit higher. It can be up to 5%.”

The one-to-one exposure to a decline in the share price of D.R. Horton makes the trade unsuitable for the non-bullish investor, a source noted.

Fair value

Brian Bernard, equity analyst at Morningstar who covers D.R. Horton along with the top U.S. home builders, said he was bullish on the stock over a three-year period. He declined to comment on the structured note.

The company constructs and sells single-family homes.

“We have a fair value estimate of $45 a share on the stock,” Bernard said.

The stock closed at $41.16 on Wednesday.

“We think it’s slightly undervalued. It offers more upside potential than some of its peers,” he added pointing to Lennar Corp. and Toll Brothers.

Millennials’ game

One of the drivers behind the company’s growth is D.R Horton’s “Express Homes” products that targets first-time buyers.

“We are a big fan of this strategy. We believe first-time buyers will stimulate future housing demand. As the demographic trend of Millennials buying more homes continues, we are optimistic about the company’s fundamentals going forward,” he said.

Resilience to interest rate

Home builders saw their stock prices rally last year. Now the trend has moved the other way with the sector lagging.

“They were high-flying stocks in 2017 because people were looking at the low supply of existing homes,” he said.

“Now everybody has switched. The main issue is interest rates rising. But this whole thing about higher mortgage rates jeopardizing housing growth is overblown in my view.”

Interest rate risk is not as big a threat to home builders as it is to other corners of the real estate market due to the economic and demographic trends that continue to support this sector, he noted.

“As long as rates are rising in tandem with the economy we don’t see it as a significant problem.

“Even if the affordability was getting tougher, D.R. Horton has the flexibility to build many smaller units,” he said.

Does that mean D.R. Horton would be thriving in a recession? As any cyclical stock, the answer is no. But Bernard was still relatively optimistic.

“Of all the home builders D.R. Horton is definitely the best positioned to benefit from the growth of the first-time buyers’ market. Its gross margins have been stable.

“Now if we have a recession, everything is possible. This particular sector would be hit the hardest. That’s kind of the risk but we don’t think it’s going to happen looking at the market fundamentals, the population growth and the supply of existing homes.

“If we did have a recession, D.R. Horton may be in a little bit more risky positioning due to some of its speculative sales strategies. But by the same token, the company probably has the best balance sheet of all the builders. This balance sheet can whether the storm.”

For income investors who are not too concerned about a downturn over the next 12 months, the notes offer the opportunity to earn a nearly double-digit coupon without contingency, the source said.

BofA Merrill Lynch is the agent.

The notes will price in July and settle in August.

© 2015 Prospect News.
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