Market participants compare BMO and Scotia’s PPNs based on pricing, tenors

By Emma Trincal

New York, April 5 – Two Canadian issuers recently priced a pair of principal-protected notes with similar features except for their respective underliers and maturities. Sources compared the two offerings from a pricing standpoint.

Bank of Montreal priced $1.17 million of two-year market-linked notes linked to the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus any index gain, subject to a maximum return of par plus 17.7.

Separately, Bank of Nova Scotia issued $4.76 million of six-year Market Index Target-Term Securities linked to the Dow Jones industrial average, according to a separate 424B2 filing with the SEC.

The payout at maturity will be par plus any index gain, subject to a maximum return of par plus 70.5%.

Both notes will pay par if the index finishes negative.

Too pricey

A financial adviser was not impressed.

“You may not get any upside and you’re capped. I have a problem with that,” he said.

“To buy the principal protection is so expensive, I’m pretty negative on these products. If you’re that concerned about the downside, you’re better off staying away from the stock market entirely.”

“You’re getting 8% or 9% best case scenario without any jump or leverage. If the market is flat, you’re going nowhere. It’s nice to get your money back. But you also want to make money.”

The two-year notes pay a maximum return of 8.5% on an annual compounded basis. The six-year note is capped at a 9.3% per year compounded return.

Dividends

“One-to-one on the upside, capped...it seems like an insurance product with a big price tag to me,” he said.

The chances of being capped out in both deals were high, he noted.

“You’re going to underperform half of the time. And you may not need that full downside protection at all. You’re paying for it.”

The longer-dated note raised an additional issue: “giving up” six years’ worth of dividends, he noted.

The Dow Jones pays 2.15% in dividend yield versus 1.68% for the S&P 500 index. And the notes tied to this benchmark are three-times longer.

“I’d much rather buy digital notes especially when they come with a minimum return and unlimited upside,” he said.

“Here with these two offerings, you have no return enhancement. You eliminate the chances of losing money, but you’re guaranteed to underperform the index.”

Time value

A structurer looked at both products and explained why the longer-dated note paid a higher coupon.

“I can see three reasons why the deal on the Dow gives you more yield,” he said.

“First the forward is cheaper on a per annum basis.”

The forward rate is the interest rate used to compound or discount the price of an option contract at a future date. The price of the forward contract is determined mainly by interest rates and dividends.

“The first thing I do when I price an option is to look at the forward first, even before looking at the volatility.”

The higher the dividend of the underlying, the lower the forward, he explained.

“Since the Dow pays a higher dividend yield than the S&P, the notes tied to the Dow will price better,” he said.

The second factor was volatility.

“The Dow has a lower volatility than the S&P. With principal-protected notes, you’re long volatility so pricing is better when vol is lower,” he explained.

Finally, the longer duration of the notes tied to the Dow played an important role as well.

“Options are cheaper on a per annum basis when you go longer.”

Short versus long

Would investors in general tend to prefer the higher-yielding but longer-dated notes versus their exact opposite? A buysider offered an answer.

“In our experience, investors always prefer shorter tenors. But these are also people new to structured products. For the experienced folks who know those products quite well, duration is not the number one factor. In fact, given the choice they tend to prefer longer terms because they price better,” he said.

When it comes to participation notes without callability, savvy investors familiar with secondary market pricing are not intimidated by longer tenors, he added.

“Clients with experience don’t necessarily hold bullet notes to maturity. When the paper appreciates in value, they sell it prior to maturity. If you’re not a buy-and-hold type of player, the length of the note is not that relevant.”

BMO Capital Markets Corp. distributed the Bank of Montreal offering.

The notes (Cusip: 06374VR32) carry a fee of 0.25%.

The agent for the Scotia notes (Cusip: 06418G404) was BofA Securities, Inc.

The fee is 2.5%.

Both deals will settle on Thursday.

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