Scotia’s autocall market-linked step-up notes on Russell 2000 seen as bet on economic recovery

By Emma Trincal

New York, May 6 – Bank of Nova Scotia’s 0% autocallable market-linked step-up notes due May 2025 linked to the Russell 2000 index is seen as a bullish play on the economic reopening as small-cap companies will fare better in a short-lived recession, a market participant said.

The notes will be called at par of $10 plus an annualized call premium of 7% to 8% if the index closes at or above the initial level on any annual observation date, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not called and the index finishes above the step-up value, 140% of the initial level, the payout at maturity will be par plus the index gain.

If the index finishes at or below the step-up level but at or above the initial level, the payout will be par plus the step-up return of 40%.

Investors will receive par if the index finishes flat or declines by 15% or less and will lose 1% for every 1% that it declines beyond 15%.

Buffer

Despite the annual autocall feature, the notes are relatively bullish, the market participant said.

“It’s probably interesting for the client who believes the stock market will rebound and grow in the next five years.

You’re giving up dividends for that period, which is the tradeoff for the 15% buffer. It protects you somewhat. But 3% a year is not much of a buffer.”

The notes could fit a bullish outlook thanks to the uncapped exposure at maturity in the absence of a call.

But in his view, the note was designed for bulls because one needed to feel comfortable with a 15% buffer, which in his view was not enough for this index.

“You have to believe the economy will recover and that it will be reflected in the stock market,” he said.

“I’d rather do that with the S&P.”

Small and fragile

Small-cap stocks may be more vulnerable to the current crisis, he said.

“Small-cap companies don’t have the firepower to endure the shock created by this Covid-19,” he explained, especially if they have debt or are exposed to struggling industries or sectors.

“I personally believe that large companies will recover faster. They’ll be better positioned than small ones to withstand the storm,” he said.

He offered the example of “Big Tech” stocks.

“Companies like Microsoft, Amazon, Netflix have not suffered at all compared to the rest of the market, quite the contrary,” he said.

The share price of Netflix Inc. is up 34.2% year to date. Amazon.com, Inc. has gained 27.25% and Microsoft Corp., 15.75%. Meanwhile the S&P 500 index has fallen by 12%.

The reopening of the economy will be slow, and companies will be struggling along the way, he predicted.

“Fewer people believe in a V-shape recovery. It may be more of a U-shape. We already have millions of jobless people,” he said.

“Larger companies have more money to shift into different businesses or regions. Just look at how big banks have relocated their trading rooms into different locations.”

Term structure

Another drawback was the five-year maturity, which represented an opportunity cost.

“The volatility curve is inverted right now,” he said.

“You can make great products on three, six or nine months. Beyond that you’re missing out on the real interesting opportunities of the volatility curve.

“Five years is too long for me.”

Net positive

An industry source said he liked the deal, finding the downside protection appealing even though his economic outlook was somewhat pessimistic.

“With a 15% hard protection I like the product,” he said.

“The terms are very compelling. You capture an 8% type of yield with a buffer. That’s good.

“People want to be able to hedge a big pullback.”

The note, he added, pays a call premium, not a periodic income such as autocallable contingent coupon deals.

“It’s not a pure income play but the yield is attractive,” he said.

In addition, the structure offers a memory feature: the call premium is accumulated each year so that investors do not miss any payment if they fail to be called on any given year.

Despite the current crisis, this source considered the buffer to be sufficient.

“Having a buffer is always a net positive. We’re moving into the unknown. People talk about a V-shape recession. I see it more like a W-shape. There is so much uncertainty right now, especially in the industries hit by the coronavirus like travel, airlines, restaurants... You do need protection,” he said.

This industry source did not object to the use of the small-cap benchmark as the underlying.

“We’re seeing increased interest in small-caps,” he said.

“Volatility is higher on the Russell. It’s the lowest performer. For some, the Russell is a smarter play than betting on the high-flyers crowding the large-caps space.”

BofA Securities, Inc. is the agent.

The notes will price in May and settle in June.

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