Scotia’s leveraged notes tied to best-of indexes reintroduce a forgotten correlation play

By Emma Trincal

New York, Dec. 13 – Bank of Nova Scotia’s 0% Accelerated Return Notes due December 2026 linked to the best performing of the S&P 500 index, the Russell 2000 index and the Nasdaq-100 index are bringing back to the market a quasi-obsolete structure, a distributor said. While billions of dollars of worst-of notes have been sold in the past decade, best-of notes are rare although popular among advisers.

The payout at maturity will be par plus 200% of the return of the best-performing index, subject to a capped return of 25% to 29%, according to 424B2 filing with Securities and Exchange Commission. The exact capped return will be set at pricing.

Investors will be fully exposed to the decline of the best-performing index.

“I haven’t seen a best-of in years,” said Brady Beals, director, sales and product origination at Luma Financial Technologies.

Best-of notes versus PPNs

He compared the pricing of this best-of with that of a few principal-protected notes (PPN) he recently spotted.

“While this best-of has no downside protection, it’s relatively safe by virtue of giving you exposure to the best performer,” he said.

Beals said he recently came across a three-year PPN on the S&P 500 index with a one-to-one upside exposure up to a 26.7% cap.

“On three-year notes, I see PPNs with caps in a 25% to 27% range.

“So, I think this one is OK,” he said.

One advantage of this best-of note over a PPN would be the tax treatment.

“Here, you probably get long-term capital gains as opposed to ordinary income taxes with a principal-protected note,” he said.

Correlations

The choice of the indexes, which currently exhibit strong divergences in their respective returns, was appropriate, he noted.

“The Russell has been a laggard. Are you betting on a reversal? This trade could be a bet between small-cap and tech,” he said.

The Russell 2000 index is up 6.2% for the year while the S&P 500 index has gained 22.2% and the Nasdaq, 40.2%.

“Correlations are much lower between those three. If you buy this, you want this trend to continue because you’re taking on less risk. When correlations increase, pricing becomes more attractive because you may have a low or negative return,” he said.

The opposite is true with worst-of. Investors in worst-of notes would rather have exposure to highly correlated indexes, which should reduce the dispersion risk. But less risk also means less attractive terms, he said.

Narrow band

“This note reflects a pretty limited range-bound view,” said Steve Doucette, financial adviser at Proctor Financial.

“You only need the best-of to be up 5% a year approximately. You have 2x leverage. If the return is more than 5% a year you blow up the cap.

“It’s a limited view. I can’t really imagine how you outperform on the upside.”

Downside

The downside payout offered some advantages with the possibility to outperform.

“The only good part is the best-of on the downside. If the Russell is down 5% and the two other indices are down 20%, you’ll lose only 5%, not 20%.

“That’s a huge outperformance. You beat the other two indices by 15%.

“You might outperform but you don’t have any protection. You’re pure long one of those indices.

“However, it’s still a good outcome since you’re going to do better than the other two,” he said.

The range-bound or mildly bullish market view associated with the structure did not match Doucette’s outlook.

“I don’t think the market is going to be up less than 5% a year for the next three years,” he said.

“If that’s what you expect, you have some kind of a bearish view. I don’t.

“This note gives you only a slim chance of beating the market on the upside.”

Divergences

Doucette said he would try to rearrange the terms in order to improve the payout.

“First, I would try to find out how much more cap can I get if I bring down the leverage,” he said.

To strengthen the payout, he offered a “creative” suggestion.

“How about replacing the best-of by a worst-of but only on the downside and add some protection? It would be a way to free up some capital to play with the cap, raise it, and possibly increase the leverage too,” he said.

“I’m not sure issuers get to be very creative but that may be a way to make the upside more attractive.”

BofA Securities, Inc. is the agent.

The notes will price and settle in December.

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