RBC buffered bullish digital notes linked to S&P play to low volatility outlook, analyst says

By Emma Trincal

New York, Sept. 4 - An expectation that the S&P 500 index's volatility will stay low is making a category of investors comfortable with structured notes that are neither principal-protected nor do they offer the potential for high returns - all while involving substantial risks, said structured product analyst Suzi Hampson at Future Value Consultants.

An example is an offering of buffered bullish digital notes due Sept. 19, 2011 from Royal Bank of Canada that are linked to the S&P 500 index.

The notes have a return that will not exceed 13.5% in two years. They are not principal-protected and the investor may lose up to 85% of the principal, according to preliminary term sheet filed with the Securities and Exchange Commission.

For investors, the low volatility of U.S. stocks justifies investing in this type of deals.

But for issuers, the low volatility of the underlying index has made products "harder to structure." The key to this particular transaction from the structurer's standpoint is to target a bullish investor for whom a strong decline in U.S. stock prices is an unlikely scenario.

Since its peak last fall, the S&P 500 index's volatility has progressively declined.

One way for issuers to compensate is to extend the terms of their deals in order to be able to offer better returns, Hampson noted.

Commenting on the RBC buffered notes, she said: "Two years is quite a long time for U.S. products" adding that most structured notes are shorter than one year right now.

"But over the past six months, we've definitely seen more long-term products because interest rates are so low. Unless you're offering longer-dated maturities, it's getting harder to structure products that are attractive," she said.

For the investor, the structure offers pros and cons and it only makes sense when one assumes that the S&P 500 volatility will remain subdued.

A flat S&P will work

One of the advantages of the RBC buffered bullish digital notes is that earning the return does not require anything more than minimal growth in the underlying index.

If at maturity the final index level is greater than the initial value, the payout to the investor will be par plus 13.5%, regardless of the percentage growth of the underlying index.

"All you need is for the S&P 500 to stay level in order to pocket your digital coupon," said Hampson.

However the digital structure also means returns cannot exceed 13.5% of the principal in two years, or 6.75% annually.

"This is not a massive return. It's capped," Hampson said. "If you're an investor happy with those returns and you don't expect the S&P 500 index to move very much in the next two years, then that would be a good option for you. But there is a lot of downside risk and the investor needs to take that into account."

On the downside, a jump in volatility is a major risk for the noteholder.

"If volatility goes up, you're likely to go below the buffer," said Hampson. The investor will not receive par if the index declines below the 15% buffer and may even lose as much as 85% of his principal.

"Although you have all this risk, you have a cap. And it's only 6.5% a year," said Hampson.

As a result, Future Value Consultants assigned a low overall rating to the deal: 3.2 on a scale of 0 to 10. Hampson though said that the rating is likely to change when the notes price on Sept. 14.

In its methodology, Future Value Consultant breaks down its overall rating into three components, all scaled from zero to 10: value rating, which reflects the price of the underlying taking into account duration; simplicity rating, which rates the product type and the level of complexity of the structure; and return rating, which predicts loss and return probabilities. Combined, value rating and return rating represent 80% of the weighting for the calculation of the overall rating, and both components for the RBC notes - at 1.20 and 2.79 respectively - are "low," according to Hampson.

Volatile product, less volatile underlying

In the RBC structure, investors holding the notes have a 20% chance of losing more than 5% of their principal, according to Future Value's analysis.

That is "quite significant in the lapse of two years," Hampson said.

Investors interested in this structure are those who anticipate that the market will not fall by more than 15% over the two years and that during the period, the S&P 500 will post some gains, no matter how small.

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