RBC’s notes tied to S&P 500 offer absolute return with a buffer, but upside is cut in half

By Emma Trincal

New York, Nov. 9 – As more investors believe that a pullback is hovering on the horizon, adding to an absolute return note a hard buffer is appealing, buysiders said. But one cannot be too bullish because the attractive package comes with a hefty price tag on the upside, they noted.

Royal Bank of Canada’s 0% absolute return notes due June 2, 2021 linked to the S&P 500 index will pay at maturity par plus 50% of the positive return if the index is up, according to an FWP filing with the Securities and Exchange Commission.

If the index falls by up to 19.5% to 22.5%, the payout will be par plus the absolute value of the return.

Otherwise, investors will lose 1% for each 1% decline beyond the buffer, with the exact rate to be set at pricing.

Interesting buffer

“I’ve never seen a buffer on an absolute return,” said Steve Doucette, financial adviser at Proctor Financial.

Absolute return notes indeed tend to be built on “soft” protection or barriers.

“You can outperform considerably if the market is down. If it’s down 20% you’re up 20%. You beat the market by 40%. That’s huge,” he said, using 20% as a hypothetical buffer amount.

Because the index decline is buffered, investors can continue to outperform the benchmark on the downside even outside of the absolute return band with a price drop in excess of 20%.

“You can go down further...The buffer lets you outperform all the way down,” he said.

For instance if the index drops 35%, investors will only lose 15%.

Tradeoff

Pricing a buffer and an absolute return feature together must be expensive, he said.

A tradeoff is expected, but for Doucette, losing half of the positive performance of the index is relatively unappealing.

“That’s a lot,” he said.

Even by historical standard – he considers the historical average return of U.S. equities to be around 6% to 10%, picking the 8% mid-point – there is a difference between getting 8% a year versus 4%, he said.

Over the term of the notes, an 8% annual return would generate only 14% in positive return instead of 28% without taking into account compounding, he added.

“I don’t know that I’d be willing to give up half of my returns. You’d have to be a complete bear.

“I’m not having that bearish tilt that I’m willing to lose half of the gains.

“In three-and-a-half years, the market could go down first and then move all the way back up.”

Here’s an idea

But Doucette, who still likes the use of a buffer instead of a barrier in the structuring of the absolute return note, came up with a suggestion for the issuer.

Reducing the upside participation below 100% was probably required to combine pairing of the two downside features. But he said he would not want to give up as much as 50%. Perhaps giving up 25% and keeping 75% of the gains would be a “decent” compromise.

This probably would require reducing the size of the buffer. But what about the absolute return range?

He came up with the following idea:

“We assume that the buffer has to be aligned with the absolute return range. Twenty percent for the buffer and 20% for the absolute return. I would drop this assumption and speak to the bank to find out if I could have the 20% absolute return range with a smaller buffer, for instance 10%,” he said.

Less hedge, more gains

In his concept, a decline in the S&P 500 index of up to 20% would guarantee a positive return of the same amount. But if the index was to drop further than that, for instance if it declined by 22%, no more absolute gains would be permitted. However the buffer would cushion 10% of such loss, allowing the investor to lose only 12%.

By taking more risk on the downside, such as losing 12% from a 22% drop instead of losing nothing with the existing product, Doucette said he hoped he could increase its upside participation well above 50%.

“I’m not an option guy but I think it would be interesting to explore something like that. It would allow me to increase my upside even if I still give up 25% of it. You never know what’s going to happen in three-and-a-half years. And on the downside, I would be able to continue to use this very neat combo of absolute return and buffer that makes you beat the market if it drops.”

Doucette said no one knows for sure what the market will be like when the notes mature.

But some investors are decisively bullish over the term of the product.

Bullish take

“I’m bullish on the U.S., just not as bullish as I used to be. Maybe I’m a little bit more bullish on Europe or emerging markets,” a buysider said.

“We’re starting to tighten here and they’re still loose.

“You got to follow liquidity. If you follow liquidity you can always be bullish.”

However, this buysider remains confident about the U.S. market. The monetary tightening has been happening incrementally without upsetting investors. He also believes that the president’s agenda can still drive the bull market even if a tax reform does not pass as quickly as the markets would hope.

“I don’t think you’re going to get 20% down for the rest of the Trump administration,” he said.

Support

A 20% drop in the S&P 500 index would push its price down to 2,065, based on Thursday’s close of the index at 2,585.

“This 2,065 is a very significant level. It has been significant for all of 2017 and half way through 2016,” he said.

“It started as a resistance level and became a support. It has been dancing around that level.

“Are we going to go back down to 2,065? I don’t see it.”

Given the three-and-a-half year term, this buysider was also skeptical about the bearish bias of the investment.

Tenor and risk

“Not only I don’t see it down 20% in three-and-a-half years, I just don’t see it down, period,” he said.

“Anytime you invest for less than 12 months that’s when you should have protection.

“The longer the time horizon, the less protection you need.

“Time heals all wounds.

He concluded that purchasing the protection and the absolute return was too expensive and that investors would have no use of these features.

“And since it’s European, I can do without the buffer.

A so-called European option is one observed point to point as it is the case with this 20% buffer measured from the initial price to the final price. Those options are less risky than the “American” type, which can be exercised during the life of the note.

“Giving up 50% of the upside for something I don’t believe I’m going to need doesn’t really make sense to me,” he said.

RBC Capital Markets, LLC is the underwriter.

The notes will price on Nov. 27 and settle on Nov. 30.

The Cusip number is 78013GLK9.

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