Scotiabank’s Accelerated Return Notes tied to Russell 2000 seen as mildly bullish yet risky

By Emma Trincal

New York, Sept. 6 – For a bet that is not overly bullish at all, Bank of Nova Scotia’s 0% Accelerated Return Notes due November 2019 linked to the Russell 2000 index could use some downside protection, advisers said.

The payout at maturity will be par of $10 plus triple any index gain, capped at par plus 10% to 14%, according to an FWP filing with the Securities and Exchange Commission.

Investors will be exposed to any index decline.

Best-selling ARNs

BofA Merrill Lynch is the agent for the notes, which are commonly sold to the wirehouse’s clients under the “Accelerated Return Notes” or ARN brand.

The last ARNs sold by the brokerage house on the Russell 2000 index came out on Aug. 30 when AB Svensk Exportkredit priced $22.36 million of the same term and structure with a cap of 10.89%.

But for RIAs, the product would be a tough sale.

“You’d have to expect the index to go sideways. It’s a hard scenario for me to envision. We have a momentum right now but no one knows how it’s going to turn,” said Steve Doucette, financial adviser at Proctor Financial.

“Will it continue for the next 14 months? I don’t know.”

Mildly bullish

The leverage with a multiple of 3 is mostly helpful to investors who are not particularly bullish given the cap, he noted.

Investors may expect a maximum return comprised between 8.5% and less than 12% on an annualized compounded basis depending on where the cap falls within the 10% to 14% range. The exact cap will be set at pricing.

But such return is achievable with a very small gain in the index – merely between 2.85% and 4%.

“I guess it’s not a bullish bet. And yet, you go out and invest without any protection. That’s a strange view,” he said.

“If I can tolerate full exposure to losses, I have to be confident.

“If I wanted to get exposure to the Russell, why would I cap myself?

“If I’m a bull, I’m going to bet on the exuberance, on the momentum. I’m not going to cap myself out.”

Missing buffer

The tenor was also problematic.

“Everybody is predicting we’re good through 2019 or most of 2019. The note pushes us to the end of 2019. What will the market be like then? We don’t know. But we know that when things go up too high, they fall down too fast,” he added.

The idea of the notes expressing a “mildly bullish” view is in accordance with the upside scenario.

“You don’t have high return expectations. The cap is so easy to hit. Fine,” he said.

But on the downside, how can investors lacking a bold conviction be so easily willing to put their entire principal at risk, he asked.

“If I was confident in my mildly bullish view, I would add protection and probably make it 2x up,” he said.

BofA Merrill Lynch offers this type of structure under its “Capped Leveraged Index Return Notes” brand.

The ARN type is usually modified as followed: the duration is extended typically to two years; the leverage decreases from 3 to 2; and a buffer is added.

Two-year buffered

A recent example of a Merrill Lynch deal was Canadian Imperial Bank of Commerce’s $19.17 million of two-year Capped Leveraged Index Return notes tied to the Russell 2000 index. The notes, which also priced on Aug. 30, featured a two-time leverage factor, a 15.4% cap on the upside and a 10% buffer.

“At first I’d say that I would go out that way,” he said.

“At least you’re picking up the alpha with the buffer. But you’re capping yourself out less than 8%. If that’s what you’re comfortable with...less than 8% a year then it’s OK. It really depends on your outlook.”

Perhaps one way to play the current “momentum” would be to use a much shorter maturity, he said.

“If I could get six months like this, I would perhaps be rolling the dice,” he said referring to the Scotia deal.

“Companies are flush with cash because of the tax code. The unemployment is low. There are tons of buybacks. I do think we still have a little bit of momentum ahead.

“If I did something like this, with no protection I would do it now and for a very short term.”

Skeptical

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he was not impressed by the risk-adjusted return of the Scotia notes, arguing that the lack of downside protection was a major drawback. The underlying market theme of the product was unconvincing, he added.

“It’s not that it’s a modestly bullish bet. I would say it’s a skeptical bet,” he said.

“It’s skeptical on the growth of the index since it doesn’t take much to hit the cap an yet you’re doing it because you don’t want to miss the return. I’m not sure I see the point of this strategy.”

Term, protection

Medeiros said that usually investors accept a cap as a tradeoff for some downside protection. The notes did not offer this particular tradeoff. In his view the shorter term and 3x leverage did not make the cap more tolerable.

“If there’s not downside protection, which is why I would buy the note in the first place, then what’s left?”

“We like this asset class and with the cap set as it is, I don’t see much benefit to this note,” he added.

The adviser also said the timeframe of the deal was a bit short.

“Because it’s short-term it’s precisely why you want the downside protection,” he said.

“You need a buffer even if you’re bullish because you want to be pessimistically optimistic.”

By not providing any cushion on the downside and limiting the return, the notes did just the opposite, he said.

The deal will price in September and settle in October.

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