Scotia’s $4.12 million capped leveraged notes on S&P 500 offer short-term bet with buffer

By Emma Trincal

New York, March 7 – Bank of Nova Scotia’s $4.12 million of 0% capped buffered enhanced participation notes due April 5, 2023 linked to the S&P 500 index provide enhanced return exposure over a short period of time with a double-digit potential return and a hard protection, features many advisers tend to find attractive.

The notes differ from similar leveraged capped products with the inclusion of a buffer despite the very short duration. Advisers’ acceptance of the short tenor varied based on their market view. But their opinion on the structure reflected the degree by which they felt comfortable with the geared buffer favorably or not.

If the final index level is greater than the initial level, the payout at maturity will be par plus 150% of the index return, subject to a cap of 13.8%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index finishes flat or falls by up to 12.5% and will lose 1.1429% for each 1% index decline beyond 12.5%.

Good start

“It’s not a worst-of. It has a buffer. And I always have to have S&P exposure in my portfolio, regardless of what the market does. So those are good things,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“Does it meet my main criteria? Am I better off with the notes or holding the position long?

“Well in this case it’s almost a wash to me.”

Kunhardt was comfortable with the cap but not so much with the downside structure.

“The cap is not bad. I wouldn’t expect the market to produce more than 13.8% over 13 months. Of course, some people do. We’re in the middle of a war. The market right now is very stressed. You could imagine that a year from now, we would be in a much better position. This war is not going to last a year. It could actually end in matter of weeks. So yes, the market could go up much more than 13.8%,” he said.

“At that point though, if you want more than 13.8%, you’re being greedy.”

War assumptions

Kunhardt’s main objections pertained to the downside. The risk, in his view was compounded by the short maturity and the nature of the buffer.

“If I now look at the downside exposure, I’m not that thrilled with the gearing,” he said.

“Any year, the market can be down more than 12%.

“The war in Ukraine is probably going to be over in a few weeks, but it can spill over to the Baltic states.

“If Russia attacks a country in NATO, NATO is obligated to go to their defense. This is World War One all over again.”

While inclined to believe that the crisis may be short-lived, Kunhardt said he did not like the short tenor.

“If I’m wrong, there’s a big potential for losses. There is just not enough time for the market to recover if I’m wrong,” he said.

Behavioral finance

But Kunhardt added that the geared buffer did not help.

“If it was not for the gearing, I may have considered it,” he said.

He used a hypothetical index decline of 30%. The notes in this case would generate a 20% loss. A hard buffer of the same amount would limit the loss to 17.5%.

“Investors don’t always act rationally,” he said.

“Does it really matter if I lose 20% instead of 17.5%? Well, yes. That’s a 2.5% difference, and for clients it matters a lot. Investors don’t like to lose more than other people do. It’s just behavioral economics.”

Credit, fee

A financial adviser, who usually buys five-year notes, said he liked this one despite its short duration.

“It’s very straightforward. Leveraged buffered to a cap. One underlying, the S&P. Anybody knows what the S&P is,” he said.

“People don’t necessarily know the Canadian issuer. But over 13 months, the credit risk is limited. It’s an easy conversation to have.”

Another very attractive item was the 0% fee.

“That’s as good as it gets,” he said.

Tax implications

The leveraged buffer was not a concern for this adviser.

“I’m a bit of a contrarian. I actually like geared buffers,” he said.

The “baseline” buffer would be 10%, he said.

“I’m not even sure you could get 10% if there was no gearing,” he said.

“Here, you get more than 10% on the downside. On the upside, the 13.8% cap is really good.

“The whole idea is you can get much better terms.”

Geared buffers can benefit clients for another reason, he said.

“I’ve had conflicted views from CPAs. Some say the gearing is your friend because you’ll end up with the more favorable capital gains tax treatment, which may not be the case if it’s a normal buffer.”

“Since I don’t know for sure, I typically put regular buffered notes in an IRA account just to be on the safe side.

“But with a geared buffer, I can put the note in a taxable account with a reasonable amount of confidence that if it’s held more than a year, it will be treated as long-term capital gain or loss.

“I like those geared buffers for the better terms you can get and also for the tax ramifications. It gives me more flexibility,” he said.

Back-testing

Using back-testing analysis on the S&P 500 index based on 13-month rolling periods over 70 years, this adviser found that the S&P 500 index has been positive and below the 13.8% cap a third of the time.

“The leverage is going to help you there. This is the sweat spot,” he said.

“You can always make the argument that the market is down so much right now, it will rebound strongly and by the time the notes mature, you will be capped out. I don’t know if I completely agree with that.

“At the same time, being capped out at 13.8% is fine with me. I get the double-digit returns that I’m always looking for with equity-like risk. It’s not one of those 7% to 8% returns that we’ve seen recently, which are useless.”

Competitive

This adviser said he was impressed by the structure compared to other leveraged capped deals seen each month.

The “Accelerated Return Notes” issued monthly and distributed by BofA Securities for example have a 13- or 14-month tenor, a competitive cap, triple upside exposure but no downside protection.

“We see many short-term notes with much more leverage but no buffer. I’d much rather have something like this one. It’s 1.5x not 3x but you have a buffer, and the cap is still decent,” he said.

“I like this note a lot.”

Scotia Capital (USA) Inc. is the underwriter.

The notes settled on Wednesday.

The Cusip number is 0641597X8.

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