Scotiabank’s 7% STEP Income Securities tied to Microsoft stock show downside risk, sources say

By Emma Trincal

New York, Aug. 20 – Bank of Nova Scotia’s 7% STEP Income Securities due September 2019 linked to Microsoft Corp. common shares offer above-average fixed income. But sources said the 7% coupon even if stretched by 5 percentage points does not warrant taking on full downside exposure in the current market environment and at this stage of the business cycle.

Interest will be payable quarterly, according to an FWP filing with the Securities and Exchange Commission.

If the price of Microsoft shares finishes at or above the step level – 107% of the initial price – the payout at maturity will be par of $10 plus a step payment of 1% to 5% that will be set at pricing.

If the stock finishes at or above the initial level but below the step level, the payout at maturity will be par.

Investors will lose 1% for each 1% decline.

Covered call

“It’s a covered call type of arrangement. You have limited upside and unlimited downside,” said Jerry Verseput, president of Veripax Financial Management.

In a short call position, investors receive the coupon as the premium for betting that the share price won’t go above a certain strike. But if the stock falls, they may lose 100% of the value of the purchased stock minus the premium. With this note the equivalent would be a loss of the entire principal minus the 7% coupon, which is guaranteed, he explained.

“That trade might work for a while if the stock goes up. But if it falls, you’re fully at risk,” he said.

The share price of Microsoft is up nearly 24% for the year, having grown nearly twice as much as the Nasdaq Composite, which is up 13.7%.

“We’re getting at the latest stage of this bull cycle. Unless you have participated in Microsoft’s huge run up and have built a protective cushion as a result, you don’t have any type of protection besides the coupon. Your risk on the downside is pretty much unlimited,” he said.

Fee

His view on the economics of the notes however was positive.

The tenor of the notes is one year and one week.

BofA Merrill Lynch, the agent, charges a 1.75% fee, according to the prospectus.

“I don’t think it’s outrageous. If you hold it to maturity, the terms are the terms. It only impacts you if you buy it today and change your mind next week,” he said.

Verseput was more concerned about the risk-adjusted return of the product.

“Maybe the stock goes up another 20% and you’re not going to take advantage of it. You’re capped. Your upside will be 8% maybe 12% in the best-case scenario,” he said.

“Again, you get the risk-reward of a covered call: limited upside, unlimited downside.

“In order to be profitable, Microsoft would have to trade within a narrow range.”

Trade headwinds

Juan R. Perez, senior foreign exchange trader and strategist at Tempus Inc., pointed to the uncertain macroeconomic environment, arguing that the giant software maker could see its share price drop as a result of trade tensions between the United States and a number of countries in the world, in particular China.

“I call this a pretty risky bet,” he said.

“It’s based on the performance of Microsoft, so you have to take into account any type of international activity they have, any type of trade headwinds which could impact their bottom line.

“Microsoft is a global company. They’re very dependent on international sales. If they can’t export their products to Singapore or China, it’s a problem.”

The market rallied on Monday as trade talks are expected to be held this week between China and the United States. But the situation remains highly uncertain, he said.

“We don’t know at this point the consequences of those tariff wars. There is a high likelihood of retaliations. It could impact our exports and hurt companies like Microsoft that compete against other global technology firms. In the midst of those trade tensions, I doubt this can be a successful investment.

“I would need a better macroeconomic vision of the near future to be able to feel comfortable with this trade idea,” he said.

The notes will price in August and settle in September.

© 2015 Prospect News.
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