Pricing of TD Bank’s $16.35 million digital notes on Topix likely driven by negative forward

By Emma Trincal

New York, April 3 – Toronto-Dominion Bank’s $16.35 million of 0% digital buffered index-linked notes due April 30, 2025 linked to the Topix index provide the double benefit of a minimum return and uncapped participation. Such pricing over a 13-month tenor was probably made possible by a negative forward price, a structurer said.

If the index finishes at or above its initial level, the payout at maturity will be the greater of par plus 13.8% and par plus the index return, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by no more than 10% and will lose 1.1111% for every 1% that the index declines beyond 10%.

Forward

“They probably were able to price it because of the negative forward. Japanese short-term rates are near zero,” the structurer said.

The one-year Japanese government bond yields 0.02% compared to 5.04% for the one-year U.S. T-bill.

“The forward price indicates that the Topix is much lower than the spot price. It’s as if the market was telling you that the price is 90 and you’re buying it at 100,” he said.

Forward prices along with volatility are key factors behind the pricing of structured notes. To simplify, the forward corresponds to the difference between interest rates and dividends, he said.

“If you have negative or near-zero interest rates, your forward will be very low. By buying it at the spot price, you're overpaying. The difference allows the issuer to price the coupon,” he said.

Quanto

The notes offered a benefit to investors seeking a pure equity play with no exchange rate exposure.

“Notes on international indexes tend to be based on quanto options, which means that the price changes are quoted in the indigenous currency, in this case the yen,” he said.

The prospectus provided a description of the quanto.

“Because the reference asset constituents are traded in a non-U.S. currency but are not adjusted to reflect their U.S. dollar value, the payment at maturity will not be adjusted for changes in the non-U.S. currency/U.S. dollar exchange rate. The payment at maturity will be based solely upon the overall change in the level of the reference asset over the term of your notes.”

Simplified exposure

For the structurer , the quanto option makes the investment simpler for retail investors.

“Currency trading is complicated. With quanto, noteholders get a long exposure to the Topix without having to worry about currency risk,” he said.

Without quanto, noteholders would be exposed to currency risk if the U.S. dollar was to strengthen against the yen. That’s because investors would be left with less dollars back when the Japanese securities get sold and converted into U.S. dollars at maturity.

But the currency-neutral exposure works both ways. If the U.S. dollar weakened against the yen , investors would lose a significant source of return, a trader said. Such scenario is not far-stretched. The yen is trading at a 34-year low against the U.S. dollar, leaving room for a reversal, this trader noted.

“Quanto allows investors to make a pure equity bet. You are currency-neutral. You are not speculating on the yen. You leave it to the issuer to hedge the exchange rate risk,” he said.

Finally, the downside leverage applied to the protection provided additional pricing power to the issuer.

“The gearing of the buffer is a more efficient way to structure the protection,” he said.

“Without the gearing, you still would have money left. Investors would still keep at least 10% of their principal. If you can go to zero, you maximize the use of the structure.”

For bulls

Julian Rubinstein, chief executive of American Asset Management, said the buffer size was insufficient.

“This is a bullish trade. I tend to be conservative. I like to see more downside protection,” he said.

A growing number of investors have been piling on Japanese equities lately. The Topix has recently hit a new record high for the first time since 1989. The Japanese benchmark is up 14% year to date and has gained 36% over the past year.

“If the Japanese market is up or at least not down, you will do well,” he said.

“But on a 13-month, I want to see a bigger buffer.”

For the same 13-month timeframe, Rubinstein would be willing to replicate the payout but with the S&P 500 index and a 20% buffer.

Investors incur greater market risk over shorter tenors as the time to recover from a pullback may be too short.

“The longer the duration, the better,” he said.

The upside payout was valuable for a bullish bet, he noted.

“It’s nice to have a digital that’s uncapped.

“But I prefer to have a cap and more downside protection.”

TD Securities (USA) LLC and Goldman Sachs & Co. LLC are the agents.

The notes settled on Wednesday.

The Cusip number is 89115FWP2.

The fee is 0.82%.

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