RBC’s $750,000 autocallable contingent coupon notes on two ETFs a play on value versus growth

By Emma Trincal

New York, Sept. 30 – Royal Bank of Canada’s $750,000 of autocallable contingent coupon barrier notes due Oct. 3, 2024 linked to the performance of the Financial Select Sector SPDR exchange-traded fund and the Technology Select Sector SPDR ETF provide a double-digit coupon based on the divergent performance of two sector ETFs, reflecting the disparity between value and growth. One adviser emphasized the market risk of the notes at maturity while another focused on the reinvestment risk anticipating an early redemption.

The notes pay a contingent quarterly coupon at the rate of 10% per year if the worst performing ETF closes at or above its coupon barrier, 80% of its initial level, on the relevant observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus the coupon if the worst performing ETF closes at or above its initial level on any quarterly observation date.

If the notes are not called, the payout at maturity will be par plus the final coupon unless the worst performing ETF finishes below its trigger level, 80% of the initial price, in which case investors will be fully exposed to the decline of the worst performing ETF from its initial level.

Performance

Steve Doucette, financial adviser at Proctor Financial, stressed the low correlation between the financial and tech sectors, which is a risk factor in a worst-of.

“You look at the two funds. For a while tech has done much better. I don’t know which one of the two is outperforming right now. But I doubt they’re correlated,” he said.

The funds’ respective performances have indeed been strong since the March 2020 correction thanks to back-and-forth rotations from cyclical stocks into tech stocks and vice versa.

The Technology Select Sector SPDR fund has gained 121% since the March 2020 bottom, slightly outperforming the 116% return posted by the Financial Select Sector SPDR during the same period.

However, on a year-to-date basis, rising yields have reversed the trend, the Financials ETF jumping 30.8%, strongly outpacing the tech fund, which rose 19%.

Higher interest rates weigh on the valuations of big mega cap tech stocks as higher rates decrease the discounted future cash flows used to value growth stocks.

Low correlation

As Doucette expected, the two underlying funds display a weak correlation to one another. The three-year coefficient of correlation between the two is 0.751.

Other sectors in the SPDR family of funds offer a much tighter correlation. For instance, the Industrial Select Sector SPDR and the Materials Select Sector SPDR have a 0.908 coefficient of correlation, which obviously is the result of the overlapping businesses they represent.

But compared to the broader markets, the correlation between the two underlying ETFs is weak. The S&P 500 index and the Dow Jones industrial average for instance have a 0.983 coefficient of correlation.

Barrier at maturity

Doucette did not think the protection was adequate relative to the potential return.

“Theoretically, the 80% barrier over three years should be OK. But you’re taking a lot of risk for a capped return,” he said.

“This note is for income and should be in your income portfolio. And an 80% barrier is a lot of risk for income,” he said.

In the absence of a call, investors may face too much risk at maturity.

“You could collect for one year and then the market is down. You’re fully exposed,” he said.

“I’m more concerned about the risk of losing principal than the risk of missing payments.

“After all, a 20% drawdown is how we define a bear market.

“In three years, you could be caught at the wrong time and lose 30% or even 40% of your assets.

“I don’t think the risk-reward is very appealing on this one.”

Short-term bet

Another financial adviser was more concerned about reinvestment risk than market risk.

“This is the growth versus value theme except you’re only betting on the worst of the two,” he said.

“We’ve seen a tremendous rotation into value from growth,” he added. As a result, the two sectors do not always move with the same magnitude.

Regulatory crackdown on tech companies and rising interest rates have put some pressure on growth stocks, he noted.

Despite those risks, this financial adviser said the notes were likely to have a short duration.

“You could see a couple of quarters of payments. There’s not a high correlation but the correlation is not negative either. You could imagine both ETFs up with one up more than the other.

“This note is almost certain to be called away,” he said.

The note was “definitely for income,” but over a very short-term horizon, he added.

“Unless the market crashes, you’ll get your coupon. But not for long,” he said.

“Alternatively, if you have a bearish outlook, it’s a short-term place to park your cash.”

Either way, investors will be subject to “call risk” because the duration of the notes will be short.

Even if the notes were to mature, the market risk at maturity would be limited, he said.

“I don’t see a scenario where you would be down 20% in three years. The 20% barrier is strong enough three years out.”

Unrewarding

Focusing on the high likelihood of an early call, this adviser said the reinvestment risk made the trade irrelevant.

“Is it worth investing in it? It’s such a short-term play. And you pay the fee upfront.

“There’s a lot of due diligence to put money to work in this for what’s likely to be a three-month note.

“What’s going to be available in three months?

“I don’t find it very exciting,” he said.

RBC Capital Markets, LLC is the agent.

The notes settled on Thursday.

The Cusip number is 78016F2L7.

The fee is 1%.

© 2015 Prospect News.
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