RBS' capped principal-protected notes linked to S&P 500 cut risk but don't eliminate it

By Emma Trincal

New York, April 15 - Royal Bank of Scotland plc's 0% capped market-linked principal-protected notes due April 29, 2016 linked to the S&P 500 index target cautious investors who are still willing to be exposed to some level of risk, notably credit risk, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par plus any increase in the index, subject to a maximum return of 50% to 56%, according to a 424B5 filing with the Securities and Exchange Commission. The exact cap will be set at pricing.

If the index declines, the payout will be par.

Credit risk

Hampson said that the principal protection eliminates market risk because price movement in the underlying index will not affect the repayment of principal at maturity.

"However, investors should be aware that they are exposed to the same credit risk as any other structured product," she said. "The repayment of principal depends on the issuer's creditworthiness."

Hampson looked at RBS' credit default swap spread and found it to be "quite high" at 180 basis points, compared with Barclays Bank plc's CDS spread at 115 bps or Morgan Stanley at 140 bps.

"With that type of funding rate, RBS is able to offer investors quite a generous cap," she said.

"This is for moderately bullish investors. They expect a 10% annual growth for the S&P 500. If you invest in a principal-protected product, it would be unrealistic to expect more than that."

One way to reduce exposure to credit risk is to invest in a shorter-dated product, she said. While five years is a long duration, it is much shorter than many other principal-protected notes, she noted.

"We've seen principal-protected deals with longer maturities, some at six or seven years or even longer," she said. "When you shorten the duration, you also reduce credit risk."

Still, buyers of those notes are willing to take credit risk and therefore are less risk-averse than buyers of certificates of deposit, she said.

"With a CD, you're not getting much more than cash returns. But you're taking risk off," she said.

Compared to a direct investment in the equity benchmark, the notes present another type of risk, she said.

"You could underperform the S&P 500 if the index grows by more than 10% a year," she said.

Compared to a fixed-rate note, this product also represents for investors a possible opportunity cost.

"They may end up not earning anything at maturity after five years," she said.

Pricing

Principal-protected notes combine a zero-coupon bond with a call spread, said Hampson. "The zero allows you to get your principal back at maturity.

"With the call spread, you sell a call with your cap as the strike price. This is your maximum return. And you buy a call with a strike of 100, so any return over par but below the cap goes to you at maturity."

With low interest rates, the pricing of zero-coupon bonds remains challenging, Hampson said. One way issuers have been able to offer principal-protected products at a lower cost is to lengthen the maturity, she said.

Another method, which Hampson said she has seen being used more often recently, is to protect only 80% to 90% of principal instead of 100%. With those partially protected structures, issuers have been able to drastically reduce duration, typically by around two years, she said.

Low riskmap

The product scores low on the risk spectrum given the principal protection, said Hampson.

Riskmap, a Future Value Consultants' rating that measures the risk associated with a product on a scale from zero to 10, is only 1.97.

"Since most of the risk is credit risk as opposed to market risk, you're going to have a low riskmap."

Return score

The return rating, Future Value Consultants' indicator on a scale of zero to 10 of the risk-adjusted return of the notes, is "above average" at 5.64, said Hampson.

This is the result of the low risk profile coupled with a "decent cap" that give investors a chance to earn potentially attractive returns, she said.

The probability tables of product return outcomes show that investors have a 45% chance of earning between zero percent and 5% a year and a 55% probability of capturing a positive return of between 5% and 10%.

The notes have a high value score of 9.10, which reflects the longer duration common to principal-protected structures, she said.

Based on a scale of zero to 10, the rating represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis.

"This is a long-term product, and our value ratings tend to favor the longer products," explained Hampson.

"Suppose you price a one-year at 95 and a five-year at 95 too. We'll give the five-year a higher value rating because we take into account the fees per annum."

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal taking into account costs, structure and risk/return profile.

The notes received a 7.70 overall score.

"It's good. It's among the best," she said.

The notes (Cusip: 78009PAF8) are expected to price April 26 and settle April 29.

RBS Securities Inc. is the underwriter.

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