Scotiabank’s $44.48 million leveraged notes tied to indexes offer short-dated, uncapped trade

By Emma Trincal

New York, Nov. 1 – A large deal, which priced last week for about $44.5 million, intrigued industry sources not so much for its size – the distributor was BofA Merrill Lynch – but for its structure. The deal, based on a familiar basket of international equity indexes, enabled investors to get almost double upside exposure over a short tenor with no cap.

Bank of Nova Scotia was the issuer with $44.48 million of 0% Leveraged Index Return Notes due Oct. 25, 2019.

The basket, which is frequently used in a variety of notes, consisted of the Euro Stoxx 50 index with a 40% weight, the FTSE 100 index with a 20% weight, the Nikkei Stock Average index with a 20% weight, the Swiss Market index with a 7.5% weight, the S&P/ASX 200 index with a 7.5% weight and the Hang Seng index with a 5% weight.

If the basket return is positive, the payout at maturity will be par of $10 plus 192% of the basket return. If the basket return is negative, investors will have one-to-one exposure to the decline, according to a 424B2 filing with the Securities and Exchange Commission.

Similar one-to-one downside exposure deals built on the same basket can be shorter, for instance 14-month but they will be capped, according to data compiled by Prospect News.

In order to “uncap” the upside, structurers often have to extend the maturity to five years, which also gives them the leeway to add a barrier.

Dividends

Talking about the two-year Scotia offering, an industry source said: “It looks pretty good. How could they do it no-cap on just two year?”

“It’s like getting a free option on the upside and what do you give up for that? The dividends... But it’s only over two years,” he said.

To be sure most of the basket components are high-yielding indexes, he said.

The S&P/ASX 200 index has a 4.25% dividend yield and the Swiss Market index yields 3.1%. But the dividend yield for the Euro Stoxx 50 is 2.35% and the Nikkei, 1.6%.

Volatility

Another factor is volatility, he added.

The implied volatility of the highest weighted index is less than 10% and so is the volatility of the FTSE 100 index.

“I guess volatility has gone down so much, you can make the bet that it’s unlikely your stocks will go up that much.”

Another way to say it, he noted, is that “investors will not get much more with the leverage.”

Negative forward

What made pricing much easier was the negative forward, he said, speaking about the Euro Stoxx 50.

The forward can be approximated by the difference between interest rates and dividends, although it is not its exact formula. As rates are higher in the U.S. than in Europe and dividends much lower, pricing on the Euro Stoxx 50 gives a negative forward, he explained.

“You can buy more option at a cheaper price so you can use more of it,” he said.

“It’s like having some sort of free option on the upside. The option is not that valuable because the forward is negative and volatility is low.

“You can pretty much get that extra leverage just by giving up dividends since the chances of the basket going up a lot are not so high.

“If two players are equally smart, but one wants to buy the ETFs in order to keep the dividends while the other is ready to give them up for the leverage, they should end up having the same outcome.”

High performance

A market participant said he was not that surprised to see a “no-cap” on a two-year leveraged note based on this basket.

“There could be an element of correlation risk in there. The basket of indices with the weightings produces more diversification. It’s not a worst-of. It’s a basket. Less correlation in a basket trade should provide less volatility and that represents cheaper call options,” he said.

“They probably ran some backtesting, looked at the performance of these indices in these ratios and determined their upside.

Some of the basket components have indeed significantly rallied this year.

The Euro Stoxx 50 index is up 25% for instance. The Nikkei gained 19%.

“They must have reached the conclusion that the difference between capping it and having it uncapped is very little,” he said.

The leverage factor was less than two times for this deal. Many similar structures offer three times, he said.

“If it was three times, same basket, same structure, you’d be capped. For this, they probably came up with this odd multiple the way they priced it, looking at what’s the most leverage I can get without a cap. And they came up with 1.92 times,” he said.

The notes (Cusip: 064161607) priced Oct. 26.

BofA Merrill Lynch is the agent.

The fee is 2%.

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