Scotia’s $28.42 million absolute return buffer notes on index basket offer risk mitigation, alpha

By Emma Trincal

New York, May 8 – Bank of Nova Scotia’s $28.42 million of 0% capped notes with absolute return buffer due April 25, 2025 linked to an international equity basket offer limited benefits on the upside, but the combination of a buffer and absolute return on the downside can reduce risk and deliver alpha.

The basket consists of the Euro Stoxx 50 index (40% weight), the FTSE 100 index (20% weight), the Nikkei Stock Average index (20% weight), the Swiss Market index (7.5% weight), the S&P/ASX 200 index (7.5% weight) and the FTSE China 50 index (5% weight), according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus any basket gain, subject to a maximum payout of par plus 20%.

If the basket falls by up to 19.5%, investors will receive par plus the absolute value of its return.

Investors will be exposed to any basket decline beyond 19.5%.

Euro-centric

Carl Kunhardt, wealth adviser at Quest Capital Management, said the product met several of his requirements based on the underlying diversification and structural features.

At first, he pointed to the fact that the basket was overweight Europe.

“Almost 70% of it is European equity. You have the euro zone, the U.K. and Switzerland. It’s a play on developed markets.

“You get a fair amount of diversification from Japan. China is too small to matter,” he said.

“Does it provide diversification? Yes. It’s 70% Europe, but in the real world, if you take out the U.S. and Canada, developed markets are predominantly European markets.”

From an asset allocation perspective, the underlying basket has a place in any adviser’s portfolio, he noted.

“Unless you only invest in U.S. equity, which would be stupid, you’re always going to have developed markets in your core portfolio. So that’s not an issue. Developed markets are going to be part of any asset allocation regardless of market conditions,” he said.

Checking all the boxes

The structure also met this adviser’s requirements when investing in a structured note.

“When I look at structured notes, I’m either looking for return enhancement or mitigation of the risk. These are the only two things I need,” he said.

The return enhancement benefits of the note were not immediately visible.

“At first glance, it doesn’t look like you’re getting any return enhancement since there is a 20% cap on the upside. The cap is not bad – 10% a year...that’s what you would expect from developed markets. But there is no leverage,” he said.

The return enhancement came from the downside.

“If I’m down 18%, I have not lost any principal, but I also have enhanced my return. I’m up 18%. That’s return enhancement. It just doesn’t come from the upside. It comes from the absolute return,” he said.

The notes also provided risk mitigation with the buffer.

“The underlying can go down 15%; I’m not losing any principal,” he said.

“So yes, aside from the diversification, I’m getting risk mitigation with this 19.5% buffer.”

Kunhardt concluded that the structure “checked all the boxes.”

“It provides me with exactly what I expect – return enhancement and risk mitigation.

“I like the notes,” he said.

Reasonable bet

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said the downside was advantageous.

“I like some parts of it for sure.

“You can make up to 20% on the upside and approximately the same on the downside.

“Therefore, you’re betting on market fluctuations between -20% and +20%, which is a pretty safe bet. The probabilities that the underlying would move within that range are reasonably high,” he said.

Chisholm liked the hard protection. The absolute return was an additional incentive for cautious or bearish investors.

“I don’t think those developed markets are going to skyrocket and if they’re breaking the -19.5% buffer level, you’re protected. If you’re down more than the buffer you have this 19.5% portion that’s protected, which I like,” he said.

“The absolute return is great. It’s a way to outperform a long position in the basket.”

Chisholm did not have a particular view on any basket components. But the representation of six different markets with different weights was a plus.

“It’s diversified; that’s the advantage of having a basket as opposed to a worst-of,” he said.

“I like Japan because it’s cheap and it has been for many years. I would rather have the hedged version of the Japanese index though because of the issue with the yen.”

The fluctuations of the Japanese yen relative to the U.S. dollar expose noteholders to exchange rate risk, especially if the yen depreciates against the dollar, which has been the trend for this currency since the beginning of 2021.

“I wouldn’t touch China but the 5% weight is not going to hurt me,” he said.

A dangerous world

Scott Cramer, president of Cramer & Rauchegger, Inc., was not enthusiastic about the notes.

“I’ve always had some issues with absolute returns, but at the same time, this is what makes the deal intriguing,” he said.

Any price decline above the buffer strike would generate alpha, he noted.

But the underlying was the sticking point for this adviser.

“I wouldn’t get excited about the notes because the underlying indices are not correlated.

“Some markets could do not so bad while others may not do well at all.”

He pointed to China as an example, saying it was not correlated to Europe.

“If Europe recovers, China may not. I’m not saying that that’s going to be the case. Only that they may not move in synch,” he said.

Cramer did not have any particular view on any of the basket components. He merely pointed to the global environment.

“Things are relatively shaky all around.

“Any of these markets could be a drag on the upside. China has potential problems. So does Japan and so does Europe or the U.S.”

Not having leverage on the upside may be the main flaw with the structure.

“You need volatility for this basket to work,” he said.

“Leverage would be great as long as I could get a similar level of downside protection,” he said.

Overall, Cramer’s view was relatively negative.

“It’s not my favorite type of note because it’s hard to say which of those markets would do best,” he said.

BofA Securities, Inc. is the agent.

The notes settled on Thursday.

The Cusip number is 06418G792.

The fee is 2%.

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