Scotia’s $10 million autocalls on S&P ETF carry excessive reinvestment risk, advisers say

By Emma Trincal

New York, Nov. 21 – Bank of Nova Scotia’s $10 million of autocallable contingent coupon buffer notes with memory coupon due Nov. 20, 2023 linked to the SPDR S&P 500 ETF Trust offer attractive features but the short tenor and lack of any call protection generate too much reinvestment risk, advisers said.

The notes will pay a contingent quarterly coupon at a 12.7% annualized rate if the ETF closes at or above the buffer level, 85% of the initial level, on the relevant review date, according to a 424B2 filing with the Securities and Exchange Commission.

Previously unpaid coupons, if any, will be automatically included whenever a contingent coupon is paid.

If the ETF closes at or above the initial level on any quarterly review date other than the final, the notes will be called at par plus the contingent coupon and any previously unpaid contingent coupons.

If the notes are not called and the ETF finishes at or above the 85% buffer level, the payout at maturity will be par plus all unpaid coupons. Otherwise, investors will lose 1.1765% for every 1% decline beyond 15%.

Too short

“For this note to stay around, the S&P has to stay in this narrow range of 0% to -15% so that you don’t get called,” said Jerry Verseput, president of Veripax Wealth Management.

“In this unlikely scenario, you get your full 12.7% coupon and principal back at maturity.”

The buffer mitigated some of the risk at maturity.

“You have a 27.7% margin of safety when you add the coupon to the buffer,” he said.

“At first glance the downside looks OK. But you’re buying this for somebody who needs the income. They can’t afford to have a lot of principal at risk. With a buffer of only 15% you stand a pretty good chance of losing some capital. It doesn’t fit the need of an income investor.”

Perhaps the main issue was the fact that the notes could be automatically called on the first observation date without any call protection.

“I don’t care for that shorter term. Three quarterly calls only. I don’t like that short call period,” he said.

“That’s the main thing I don’t like about this note.

“It’s a one-year duration and it seems like a lot of efforts for a potential three-month note. To stay negative and above -15% is such a narrow window. There are better notes than this one out there.”

Call risk

Jeff Pietsch, founder of Capital Advisors 360, expressed similar concerns.

“It gives you an attractive rate of return but in addition to the equity and counterparty risks, you have the reinvestment risk given the one-year tenor and the fact that it can be called in three months,” he said.

His view on the buffer was mixed.

“A buffer is nice but the gearing to the downside may make a lot of your clients nervous. However, since the market is already down 17% this year, there is limited risk that the gearing would come into play,” he said.

Place in the portfolio

Allocating the notes to the right place in the portfolio was this adviser’s main concern.

“I see this note as a potential income play for those investors willing to take on additional risk for a year.”

However, he would fund the investment out of the equity portion of the portfolio.

“It’s really hard to categorize this security. It’s definitely designed for income, but it’s also sort of high-yield. It’s in between because there is still a fair amount of risk in there,” he said.

“With the 15% buffer, your protection is probably adequate, but who knows? I wouldn’t be too comfortable putting this note in the fixed-income portion of the portfolio.”

Part of the problem was not just the principal at risk but also the likelihood of an early redemption cutting short the income stream.

“You can get called right away. The memory is terrific. But what’s the use if you get called in three months? That’s only one coupon payment. The memory is a moot point because the odds of getting called right away are pretty high,” he said.

Investors interested in the notes would have to have a specific market outlook.

“If you’re agnostic about the market, if you think we’ll be in range between -15% and +12.7%, that’s a good deal.

“It’s an instrument that offers balanced risk but only if you have a rangebound view.”

Scotia Capital (USA) Inc. is the agent with J.P. Morgan Securities LLC as placement agent.

The notes settled on Monday.

The Cusip number is 06417YBR9.

The fee is 0.2%.

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