Nomura’s capped notes linked to REITs, BDCs offer unusual leverage, two times up and down

By Emma Trincal

New York, Aug. 19 – Nomura America Finance, LLC’s 0% capped accelerated basket return securities due Aug. 25, 2019 linked to a basket of 10 common stocks offer access to high-yielding stocks with dividend reinvestment and a higher cap, but investors have to accept the two-times leverage on both gains and losses.

The reference asset is comprised of the common stocks of Apollo Commercial Real Estate Finance, Inc. with a 10% weight, Apollo Investment Corp. with a 10% weight, Ares Capital Corp. with an 18% weight, Ares Commercial Real Estate Corp. with a 7% weight, BlackRock Capital Investment Corp. with an 11% weight, Blackstone Mortgage Trust, Inc. with a 5% weight, FS Investment Corp. with a 15% weight, Hercules Technology Growth Capital, Inc. with a 5% weight, Starwood Property Trust, Inc. with a 14% weight and TPG Specialty Lending, Inc. with a 5% weight, according to a 424B2 filing with the Securities and Exchange Commission.

If the basket value is greater than 55% of the initial value throughout the life of the notes, the payout at maturity will be par of $1,000 plus twice the basket return, subject to a minimum cash settlement of $200 per $1,000 principal amount and a maximum cash settlement of $2,200 per $1,000 principal amount.

If the basket value is less than 55% of the initial value at any time during the life of the notes, a participation trigger will occur and the payout at maturity will be zero.

Symmetrical leverage

“I haven’t seen very often two-times leverage on the downside. What you see commonly is a delta one,” a market participant said.

“It’s simply a two-times note. Capped. While the structure is not all that sophisticated, I would guess that it’s for high net worth or perhaps institutional clients. It’s not something you would sell to your average client.”

One of the intricacies of the structure is the minimum cash settlement amount of $200 per $1,000 principal amount (20% of principal) if the trigger does not occur. In other words, if the basket return finishes negative but not down by more than 45%, investors will not lose more than 80% of their investment, according to the prospectus.

Floor

This 20% floor really only applies when the basket drops between 40% and 45%, noted the market participant.

“It’s a little bit of a floor, but it’s confusing and not terribly important. What it means is that you lose only 80% instead of 90% if the basket is down 45%. So whether you’re down 40% or 45%, it’s the same: you end up with 20% of your principal. I don’t know if people care honestly. First of all because when you lose that much money, 10% is not going to make a big difference, and second because it’s so unlikely that your basket would end up losing between 40% and 45%. ... It’s such a tiny range.”

A buysider agreed.

“Like they really had to do that? If you’re down 45, you can’t be down 90? They didn’t have any nines?” he said.

“I don’t understand that tweak on the downside. The maximum loss you can withstand is 50%. Why don’t they just start straight to that point? Maybe it has to do with how they’re reinvesting dividends.”

Business development companies, or BDCs, and real estate investment trusts are high-yielding securities. Ordinary cash dividends for each basket component are reinvested, according to the prospectus.

Covered

The market participant suggested that one of the benefits of the notes is to control the risk associated with leverage.

“It just allows you to avoid borrowing money,” he said.

“It may sound like a stretch, but one advantage of the notes is to limit the amount of your losses to your initial investment while achieving leverage.”

He offered an example: “Suppose you’re trying to replicate the two-times with a direct investment in the basket. You buy each stock.

“An equity investor with $1 million to invest would have to borrow another $1 million to get the two-times exposure.

“If the market is down 80%, this investor will lose 160%. That represents his own $1 million investment plus $600,000 of the $1 million he had to borrow initially.

“So if you look at it that way, the notes actually stop your losses on the downside.

“You can’t lose more than the cash you put in.”

The question remains whether such benefit makes enough sense and for whom.

“I don’t know if the economics work out,” he said.

“After all, there is a cap of 120%. With the two-times leverage, if the basket return is more than 60% after four years, you’re not participating in it. Roughly speaking, you get capped out when the basket is up 15% per year.”

Pure replication

The notes also offer a more advantageous type of leverage compared to an exchange-traded fund, which would hypothetically offer exposure to the same basket along with the same leverage factor.

“Leveraged ETFs are not a fair comparison because they never offer pure leverage,” he said.

“But assuming you had one equivalent to this note, you would be better off with the notes.

“That’s simply because leveraged ETFs only replicate daily moves. They don’t track two times point to point.

“So you get two types of benefits – either by limiting your losses or by getting a better tracking.

“Whether these two are good enough reasons to invest in the notes, I’m not sure.”

Cheap calls

The buysider said that he understands the need of investors to use leverage. But he does not see why it warrants taking twice the risk on the downside.

“People are gravitating around leverage right now. Two times, three times are more popular,” he said.

“It sort of makes sense. The S&P is up 1% this year.

“When people want to generate 8%, 10%, 12%, they’re going to need leverage in these low return markets.”

One way to do that, he explained, is to use reference assets that offer “cheap” call options. High-yielding stocks, when they show lower volatility levels, can help achieve that goal.

“The calls are cheap. You can build in more participation in the options with very low volatility,” he said.

“It’s not a play on real estate or BDCs. ... It’s a play on volatility.

“So you can get two-times up. And there’s an awful lot of participation, no question about it.

“But since you get to lose two times also, you really need to be a bull with strong conviction.”

The risk-return profile of the notes does not seem appealing, he said.

“Why do it symmetrically up and down with effectively no barrier or buffer, a four-year timeframe and on top of that, you get a cap?

“Seems like a coin flip to me.”

Asked about who the potential buyers would be, he said, “I don’t think it was designed for sophisticated investors. A sophisticated investor would pick a target volatility index as the reference asset, something like the S&P 500 low vol index. They would leverage that three-to-one on the up and one-to-one on the down.

“I don’t really see any reason to do this, really. That’s a head-scratcher.”

Nomura Securities International, Inc. is the agent.

The notes will price Thursday and settle Tuesday.

The Cusip number is 65539ABZ2.

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