Scotiabank’s notes linked to Raymond James CEFR Domestic Equity offer discount to NAV strategy

By Emma Trincal

New York, Jan. 27 – Bank of Nova Scotia’s 0% equity-linked index notes due Feb. 25, 2019 linked to the Raymond James CEFR Domestic Equity Total Return index give access to a strategy often used by closed-end fund investors consisting of buying the funds at large discounts to their net asset value in order to generate a return when the discount narrows. The underlying research from Raymond James, which centers on discount compression and reversion to the mean, reflects this form of arbitrage.

The notes offer one-to-one exposure to the index minus a 3% fee plus a potential quarterly coupon based on the distributions paid by the closed-end funds that make up the index, according to a 424B5 filing with the Securities and Exchange Commission.

Scotiabank priced $27.75 million of notes due Sept. 21, 2018 linked to this specific index in September. According to data compiled by Prospect News, the announced deal would be the second priced by Scotiabank based on this underlier.

New territory

“To my knowledge this is the first registered note linked to a closed-end fund index outside of the ETN space,” a market participant said.

UBS has its Etracs Monthly Pay 2xLeveraged Closed-End Fund exchange-traded notes linked to the ISE High Income index.

“There is this UBS ETN, but I don’t see any precedent in terms of U.S. registered notes,” he said.

Closed-end funds are first offered via an initial public offering and have a limited number of shares. Based on investor demand, they may trade on the exchange at a higher or lower price than their NAV.

Price deviations from NAV offer arbitrage opportunities, said Eric Boughton, portfolio manager at Deschutes Portfolio Strategies, a registered investment adviser that manages about $200 million of closed-end funds primarily within its mutual fund, the Matisse Discounted Closed-End Fund Strategy.

Record discounts

He said the methodology he uses for his own fund is similar to that employed by Raymond James, based on public filings.

“Their index overweights funds trading at larger discounts and also overweights funds exhibiting lower volatility.

“At Matisse, we use some of the same criteria when selecting CEFs for our portfolios. Our research, and clearly Raymond James’ as well, suggests that purchasing closed-end funds at large and ‘larger-than-normal’ discounts to NAV is a strategy that has led to positive alpha over time.”

The current market environment is particularly favorable to bargain-hunters in the closed-end fund field, he noted.

“The primary appeal today is that closed-end funds trade very close to record discounts to their NAV. One can create a globally diversified portfolio of stocks and bonds for 85 cents on the dollar,” he said.

“Our own mutual fund currently owns closed-end funds which trade for 82 cents on the dollar on average.

“You have to go back to 2008 to see discounts as wide as what we’re seeing today.”

Several factors explain those historical gaps, he said, citing first leverage, which is routinely used in closed-end funds.

“Investors fear rising interest rates. Closed-end funds are leveraged vehicles, and they can get hurt investors when rates go up,” he said.

“And as we all know, the market has declined in the past month. Junk bond spreads have blown out. Commodities have collapsed to lows not seen since the ’90s. Closed-end funds are one of the casualties of the general investors’ malaise.”

But he warned investors about some of the limits of the strategy.

“A discount to NAV is not a defense against losses in the NAV that comes from declining markets. However, purchasing at a large discount to NAV provides investors an excess return whenever the discount returns to normal levels.”

Raymond James index

The index created by Raymond James is composed of closed-end funds selected from a universe of roughly 560 U.S. closed-end funds that are included in either the Morningstar U.S. Sector Equity category or the Morningstar U.S. Equity category, according to the prospectus.

The index’s identifies at least 25 closed-end funds that meet certain minimum market capitalization and daily average value traded characteristics that are then given a modified volume weighting. The constituents are then ranked according to their respective discount to NAV.

“Our approach is very similar. We look for discounts to the NAV because when closed-end funds are very discounted they tend to outperform from that point forward,” Boughton said.

“So we buy at a large discount with this reversal to the mean approach.”

One difference, however, was Raymond James’ focus on equity closed-end funds only.

“An investor in the note takes on ‘full equity risk,’” he said.

Since its launch, the Raymond James index’s daily movements have exhibited a beta of 0.8 to the S&P 500, with 86% correlation, he noted.

Not many indexes

Boughton said the number of closed-end fund indexes remains scarce.

“I have been in this field for 10 years, and so far I’ve known only two,” he said.

He cited the S-Network Composite Closed-End Fund index, which he uses for his mutual fund. This index is also replicated by an ETF, the PowerShares CEF Income Composite Portfolio ETF.

The other index he mentioned was the First Trust Composite Closed-End Fund index created by First Trust Advisors LP.

Jim Kaufman, senior managing director at Aegis Capital, who used to work at Raymond James, agreed.

“The closed-end fund market is not a small universe. It’s a $300 billion market. Yet, it’s not easy to develop indexes on closed-end funds mainly because it’s such a widely diversified industry,” he said.

“You have high yield, government, REITs, MLPs, equity. To have a broad index tracking this universe, you would have to put many different sectors together, which may or may not make sense,” he said.

“Unless you create sector-specific indexes, it’s a bit tricky to track these funds via an index.”

Fee

Closed-end funds, while not a small market, are often perceived as a niche market, said Boughton.

The use of notes on a new index may bring investor attention to the possibilities offered by these instruments, a broker said.

“It may be useful to get access to these strategies through a structured note,” he said.

Because of index adjustments, fees and commissions, investors in the notes need to see the index increase by at least 4.1237% to break even, according to the prospectus.

The broker was not deterred, saying the notes could still offer a viable alternative to existing instruments.

“It’s very interesting. Yes, there is a fee, but if you are an individual seeking that type of exposure without the assistance of a portfolio manager or an adviser, it may be useful,” this broker said.

“Over the years, I have grown more and more suspicious about funds of funds, which force you to pay a double layer of fees, one for the underlying managers and the other for the manager who selects the funds. And by the way, this particular fund will generally find its way to a portfolio managed by an adviser, who himself will also charge a fee.

“So it may be a very interesting option for investors who want to access this market on their own.”

Scotia Capital (USA) is the underwriter.

The notes are expected to price Feb. 19 and settle Feb. 24.

The Cusip number is 064159HF6.

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