Scotia’s $20.23 million autocalls on ETFs show high yield but volatility, reinvestment risk

By Emma Trincal

New York, April 28 – Bank of Nova Scotia’s $20.23 million of trigger autocallable contingent yield notes due April 26, 2028 linked to the least performing of the Energy Select Sector SPDR fund and the SPDR Dow Jones Industrial Average ETF Trust offer an attractive coupon, but investors should consider the volatility of one of the underliers as well as the reinvestment risk in the likely event of an early redemption, advisers said.

The notes will pay a contingent quarterly coupon at the rate of 11.6% per year if each ETF closes at or above its coupon barrier, 60% of its initial level, on the related observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically called at par plus the coupon if the shares of each ETF close at or above its initial share price on any quarterly call observation date after six months.

If the notes are not called and the worst performer finishes at or above its downside threshold level, 60% of the initial share price, the payout at maturity will be par plus the final coupon. Otherwise, investors will lose 1% for every 1% that the final share price of the least performing ETF is less than its initial share price.

Recession risk

Scott Cramer, president of Cramer & Rauchegger, Inc., said he liked most aspects of the structure except the worst-of payout and the tenor.

“I don’t like worst-of in general, but I understand why they do them,” he said.

“The energy sector is very volatile. It could go bad under certain circumstances such as geopolitical risk or a very bad economy.

“When we had Covid, oil went negative.

“Over five years, I’m not saying it’s going to happen, but it could.”

The other underlier was less volatile.

“The Dow Jones ETF could knock out the 60% barrier, but it would only happen if we had a recession. It’s more likely that you would skip a few coupon payments,” he said.

Strong sector

Some analysts have argued that the Energy Select Sector is overvalued. The ETF, since its low of March 2020, has almost quadrupled in price. But Cramer disagreed, arguing that the skyrocketing share price reflects growth.

“The Energy Select sector is volatile but it’s not overvalued,” he said.

“I know the underlying companies. None of them is overvalued. They were overvalued in 2014 because oil was a lot higher at the time. Back then, those companies used to spend way too much on CapEx, and they had a lot of debt. It’s not the case anymore. They’ve now drastically reduced their capital spending, they’ve cut their debt, they’re paying dividends, in some cases they’re doing share buybacks.”

The top two holdings of the fund are Exxon Mobil Corp. and Chevron Corp. with 23% and 19.6% weightings, respectively.

“Overall, the risk is not in the fundamental or technicals. The biggest threat for both funds is going to be if we have a deep recession, some kind of geopolitical risk or something like Covid,” he said.

High-yield

Despite the high return offered by the coupon, investors should remember that the investment is not designed to replace an equity position.

“The five-year period is long enough to collect some decent income, especially at a rate of 11.6% even though you’re likely to miss some coupons,” he said.

“The 11.6% interest rate is generous especially if the Fed starts to lower rates.”

That’s because the 11.6% yield would be even more competitive if interest rates turned lower.

Cramer said that the consequences of a rate cut on the stock market should not impact the value of the notes.

“You could underperform the market if the Fed began to ease, because stock prices would rally as a result. But this note is not designed to beat the market. It’s an income note, not a growth product. If you bought it to participate in the market, you bought the wrong note,” he said.

Long term, short duration

Cramer expressed a balanced view about the five-year maturity.

“It’s a long tenor but you’re not going to hang around very long. After six months, you can get called and it can happen each quarter. So, chances are you won’t hold it for five years. Still, I’m not a fan of long tenors,” he said.

“On absolute terms, it seems like a good note. But I would be looking for something else. I would try to avoid the worst-of exposure and possibly, I would find a shorter note.”

Timing the call

Jeff Pietsch, founder of Capital Advisors 360, agreed that the uncertainty of the notes’ duration was one of the key issues investors needed to consider.

“Is it going to be a short-term note, or a five-year note? That’s an interesting question,” he said.

A call may not happen right away and may require certain conditions.

“The odds of being called away are very high but it might take a couple of quarters after the six months before it happens,” he said.

“That's if we enter a sideways regime. At some point though, you should get called because both funds have already recovered from their bear market lows and broadly speaking markets tend to rise.”

The call was almost certain over the five-year period. But timing it was more difficult.

“I would be surprised if the note was not called within the first year based on technical analysis,” he said.

An automatic call while eliminating market and credit risks was not necessarily a risk-free event.

“The reinvestment risk is pretty high. You have more reinvestment risk than market risk in this note,” he said.

Call risk

He brought up two factors which mitigated the risk of market losses.

“It seems like 40% is enough protection over a period of time during which you're likely to get called,” he said.

“In addition, the coupon is big enough to provide a little bit of a buffer. One quarterly coupon alone is almost 3%.”

The yield was very competitive compared to traditional fixed-income instruments, he noted, comparing it to the ongoing rate on one-year brokerage CDs, currently at around 5% per year.

“You are getting a little bit more than double that rate. It’s an attractive risk-return for sophisticated investors. It could be used in the income portion of a portfolio,” he said.

Cost

Pietsch examined the cost of the product, looking at the 2.5% fee disclosed in the prospectus.

“For a five-year note, it’s not outrageous. It’s 50 basis points a year. While the fee is baked into the structure, it’s still an opportunity cost because a lower fee all things being equal would provide better terms,” he said.

The fact that structured notes investors pay the fee upfront constituted another issue.

“It could end up being costly if you get called, especially if you get called early,” he said.

Overall, Pietsch said he liked the downside protection and the risk reward.

“You just have to be comfortable with the reinvestment risk. Finding a coupon as high as this one, even in a rising rate environment, may prove to be challenging,” he said.

Scotia Capital (USA) Inc. and UBS Financial Services Inc. are the agents.

The notes settled on Wednesday.

The Cusip number is 06418A787.

The fee is 2.25%.

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