Scotia’s autocallable bear notes on S&P 500 to offer directional bet, hedge

By Emma Trincal

New York, July 27 – Bank of Nova Scotia’s 0% autocallable bear Strategic Accelerated Redemption Securities due August 2024 linked to the S&P 500 index would work best in a market declining at a moderate pace but would still function as a partial hedge in a severe bear market, a portfolio manager said.

The lack of protection if the market rallies requires, however, a strong bearish conviction, he noted.

The notes will be called at par plus a premium of 33% to 34% per year if the closing level of the index is less than or equal to its starting value on any quarterly valuation date after six months. The exact premium will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not called at maturity, investors will lose 1% for each 1% gain in the index.

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“If you’re bearish on U.S. equity markets, there are plenty of ways on the short side. You can short the index; you can invest in inverse ETFs in your non-retirement account; you can buy put options. This note offers the advantage of generating a big gain if the market declines by only a small amount,” said Steven Jon Kaplan, founder and portfolio manager at True Contrarian Investments.

Better targets

Rather than targeting the S&P, however, Kaplan would deploy his bearish strategy on assets that are even more overvalued than the S&P index.

“I would concentrate on the “Magnificent Seven,” he said.

Those high-growth stocks – Apple, Amazon, Alphabet, Microsoft, Meta, Nvidia and Tesla – have led the bull market this year.

“Stocks like Apple, Amazon or Tesla have huge P/Es that are way out of line with their profit growth,” he said.

More conveniently, bears may consider shorting overpriced large-cap funds such as Invesco QQQ Trust, which references the Nasdaq-100 index as well as the sector fund Technology Select Sector SPDR, he said.

Speculative bubble

Still, stretched valuations make the S&P 500 index a good target for bears.

“This bearish note is one of the best I’ve seen in a long time. Even if the index drops moderately, you’re going to get your 34% annual return.”

Kaplan said many signs point to the risk of a significant drop in equity prices.

One of them is investors’ preference for risky assets at a time when Treasuries offer significantly high yields.

“At the peak of the market in January 2022, six-month Treasuries were yielding less than 0.5%. Now, they pay 5.5%,” he said.

“Why would investors pile into stocks, real estate, high-yield corporate bonds, or almost anything else when they have risk-free Treasuries as a viable alternative? These are the classic signs of a speculative bubble.”

Other signs of multi-year extreme valuations include a record low ratio of puts to calls, extreme highs in the volume of call option buying as well as unprecedented total net inflows into U.S. equity ETFs, he added.

“If you’re extremely bearish, you probably should be short the market. But this note gives you a very decent boost if stock prices drop only moderately within the next 12 months. That’s what’s attractive. A 34% annualized return without the constraints of trading on margin when you’re short or the time decay of being long puts gives you a very efficient hedge,” he said.

Losing proposition

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, who is also bearish on the S&P 500 index. did not find the hedging strategy rewarding enough.

“I am bearish, and I think it’s not unreasonable to expect the market to fall by 50%. If I get called and only capture a call premium limited to 34%, I don’t call it a perfect hedge.

“On the other hand, if the market is up 100%, I lose 100%.

“It’s a lose-lose,” he said.

“Unless the market is slightly negative, you will lose.

“I don’t see it being attractive at all.”

A good alternative

For Kaplan, the notes offered the advantage of flexibility.

“If the market drops 50% and your annualized return is 34%, you’re still better off,” he said.

Hedges are rarely perfect, and the closer they are to perfection, the more expensive they are, he said.

Short-selling for instance is riskier and has its downsides too, he added.

“You have to know how margins work and what mark-to-market means. Also, if the position moves against you, cash comes out of your account. As the position fluctuates, cash is either in or out of your account,” he said.

A market rally would put noteholders at risk. But losses would be offset by the rest of the portfolio.

“Most investors are long the market. If you lose from the notes, your equity holdings would work for you and make money. It would be some sort of a hedge,” he said.

Overall, the note offers a simple solution to investors seeking to bet against the market or mitigating downside risk.

“It doesn’t cost you any put premium. You can earn a reasonable return if the market drops moderately. It may not be perfectly liquid, but it saves you from the risks and complications of a short position. I like it,” said Kaplan.

BofA Securities, Inc. is the agent.

The notes will price and settle in July.

© 2015 Prospect News.
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