Scotiabank’s $13.76 million Mitts tied to index basket offer full capital protection, FX hedge

By Emma Trincal

New York, July 30 – Bank of Nova Scotia priced $13.76 million of 0% Market Index Target-Term Securities due July 26, 2024 tied to a basket of indexes, according to a 424B2 filing with the Securities and Exchange Commission.

The basket consists 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.

The payout at maturity will be par of $10 plus 133.75% of any basket gain.

If the basket falls, the payout will be par.

“They were able to provide the principal protection in two ways,” a market participant explained.

“First, the five-year dollar funding is higher than most currencies. The CDS spreads of Nova Scotia are probably tight, but you probably can get a good spread. Five-year gives you a decent funding,” this market participant said.

Funding levels

The current five-year CDS level for Bank of Nova Scotia is 52.78 basis points, according to IHS Markit. That is in line with some of the major U.S. issuers such as Citigroup (50.51 bps) and Morgan Stanley (54.83 bps), according to the same market information provider.

The funding rate is part of the funding cost of a bank as it is the rate at which it issues a bond. The funding rate depends on the creditworthiness of the issuer. Higher-rated banks have a lower funding cost. Funding levels have an impact on structured notes pricing, which is one of the various reasons why terms may vary from one issuer to another all things being equal.

“Dollar interest rates are lower, but they’re still higher than in other currencies,” he said, referring to negative interest rates in Germany and Japan, for instance.

This also helped in the structuring of the notes.

Principal-protected notes are built on zero-coupon bonds that provide the repayment of principal at maturity.

The higher the interest rates, the lower the price of the bond (discount), which gives the issuer more money to purchase the options.

Correlation

Another factor helping pricing, leverage in particular, was the use of an underlying basket, he added.

“It’s a diversified basket. The investor is buying correlation, and these components are not really correlated right now,” he said.

Investors are hoping that all indexes in the basket will rise at maturity in order to maximize the gain.

“The risk, however, is that in five years, some of those indices will go down even if some go up.

“That’s why the calls are cheaper. The call options are cheaper than if you were buying them on the individual indices.”

EAFE proxy

The use of this particular underlying basket is extremely frequent in the structuring of notes, according to data compiled by Prospect News. The same components have been repeatedly employed in billions of trades, with the most visible alterations happening in slight changes in the weightings. Less common, however, is its use in a fully protected note, the data showed.

Five years for a 100% downside protected note used to be a short term. Not anymore.

“Over the past year or so I’ve seen a lot of uncapped, Euro Stoxx, shorter-dated types of notes, like three year. But for the full principal protection, you need to go a little bit longer,” an industry source said, adding that five years was about right.

He explained one of the reasons behind the popularity of the basket, which groups developed markets excluding the United States and Canada in various weights.

“What this trade is doing is they’re replicating EFA,” he said.

“EFA” is the ticker for the iShares MSCI EAFE exchange-traded fund, which replicates the MSCI EAFE index, a benchmark for the equity markets of Europe, Australia, Asia and the Far East. This equity index does not include the United States and Canada.

The top regions in the ETF are currently the euro zone with a 43.3% weight, Japan with a 23.7% weight, the United Kingdom with a 16.7% weight, Australia with a 7.2% weight and Asia with a 5.3% weight, according to BlackRock Fund Advisers.

Quanto options

The notes modify the allocations somewhat, but their main advantage is elsewhere.

“The ETF is U.S.-denominated. If you were to buy or trade the ETF, you would be subject to the full currency risk. It could help you or hurt you, but you would have exposure to the risk,” he said.

For instance, an underlying equity asset could be up 10% in its local currency, but if the dollar rose by 10% as well, the note tied to this asset would be flat because the portfolio would have to be converted into dollars.

But by investing in the notes, investors are exposed to the pure price fluctuation of each local index without any conversion into dollars, a process called “quanto” in FX derivatives jargon.

This allows the issuer to build in a hedge against exchange-rate fluctuations.

“By quanto-ing it, you take the currency risk out of the equation,” he said.

“I suppose quanto options might also help with pricing, but that’s more of a question to ask a quant.”

Price return

What certainly helps pricing is the use of some high-paying dividend indexes in the underlying basket, he said.

The performance of the basket is ex-dividends, as it is the case with all structured notes. The underwriter uses the unpaid dividends to purchase the embedded derivatives.

Case in point: the FTSE 100 yields 4.3% and the Euro Stoxx 50 yields 3.65%, both showing much higher yields than the 1.8% yield of the S&P 500.

BofA Securities, Inc. is the underwriter.

The notes (Cusip: 06417P124) will settle on Thursday.

The fee is 2.5%.

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