TD Bank’s digital buffered notes due 2022 tied to Russell to offer potential alpha

By Emma Trincal

New York, Nov. 8 – Toronto-Dominion Bank’s 0% digital buffered notes due May 31, 2022 linked to the Russell 2000 index, give investors a chance to strongly outperform the benchmark in a slightly bearish or range bound market, sources said.

If the index return is greater than or equal to 85% of the initial level, the payout at maturity will be par plus the digital return of at least 21.9%, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will lose 1% for each 1% decline beyond the 15% buffer.

Digital

“It’s an interesting note. I like the small-cap space over the next three years but there are some obvious unknowns we need to be concerned with. So I think it’s not a bad idea to have this asset class in a structured note,” said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

The chance of receiving a fixed positive return in a downside scenario helped mitigate risk.

“The digital component of the offering is attractive because you can have a positive return if this portfolio is negative not to exceed 15% over the period,” he said.

Having a digital payout rather than absolute return participation was also a plus as investors are able to maximize their gain regardless of the amount of decline above the 85% threshold, he noted.

The nature of the protection was also a plus.

“I prefer a buffer over a barrier, and in this environment the buffer is particularly appealing,” he said.

Adjusting to the uncertainty

For Medeiros, the current environment could lead to more volatility.

“We just had an election and there is uncertainty about what the agendas are going to be,” he said.

“We had a very long bull market. I am not predicting a pullback. But one can only note that it hasn’t happened in a long time.”

For some bulls, having a 21.9% maximum return over three-and-a-half years might seem limited. But in a range bound or if the market stays between correction and bear market levels, the digital payout would generate alpha.

“In light of current market conditions and uncertainty, I wouldn’t be too greedy about the cap. I think it’s a well-positioned cap and a reasonable strategy,” he said.

Correction discount

The Russell 2000 index has seen more volatility than other U.S. benchmarks this year as it often is the case with small-cap equities, noted a market participant. It is still at high valuation levels however over a long-term period.

“We’re 27% higher than three-and-a-half years ago. But if you look at last summer’s all-time high, you’re getting into this trade at a pretty good discount” he said.

“We’re in correction territory.”

The Russell 2000 index, which traded at 1,573 in late afternoon session on Thursday, is 9.65% lower than its all-time high of Aug. 31 of 1,742.

Downside

The structure however added another layer of protection with the payment of a digital return if the index was to drop an additional 15% from the current price, which has already incurred a fresh correction, he noted.

“I think the entry price and the payout here should give you some comfort. I also think that 22% looks pretty good. You’re getting paid to sell the put at 85%. You’re giving up any upside but you have this return and this protection with a downside that’s quite out of the money,” he said.

Writing a put at 85% provides investors with a premium, which is the digital coupon, he explained. There will not be any loss of principal as long as the index does not drop below the 85% strike price. If it does, money is lost from the “out-of-the-money” strike, not the initial level as it is the case with barriers.

The put is said to be out-of-the-money because when the put is sold, the underlying price is above the strike price.

Note versus bond

Investors in the notes however should always compare what a structured note offers versus a plain-vanilla corporate bond, he said.

“Interest rates have gone up. You’re giving up the coupon you would get if you invested in TD paper directly,” he said.

TD Bank notes maturing on May 2022 are seen trading at a discount with a 3% coupon, according to a bond broker.

Yield-to-maturity is estimated to be between 3.1% and 3.2%.

Holding an investment-grade note of the issuer and maturity would give investor a return of approximately 11% with full downside protection.

“You’re giving up the full protection of a bond but you’re getting two-times the gain. Then it’s a matter of wanting full protection versus being happy with a buffer. Personally, I think the option is quite out of the money and that if on top of that you take into account the recent sell-off and the discounted level of the index, you’re getting a pretty decent cushion.”

TD Securities (USA) LLC is the agent.

The notes will price on Nov. 26.

The Cusip number is 89114QEA2.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.