RBC’s notes tied to EM ETF offer value, but buffer should replace barrier, advisers say

By Emma Trincal

New York, Nov. 15 – Royal Bank of Canada plans to price 0% market-linked securities with leveraged upside participation to a cap and contingent downside due Dec. 6, 2021 linked to the iShares MSCI Emerging Markets ETF, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 150% of any fund gain, capped at par plus 40% to 45%. The exact cap will be set at pricing.

The payout will be par if the fund falls by up to the contingent buffer of 25%.

Investors will lose 1% for each 1% decline of the fund from its initial level if it falls by more than 25%.

Buffer preferred

Jeff Pietsch, head of capital markets at the Institute for Wealth Management, said the notes would be more appealing with a buffer.

“Under most forward-looking scenarios, the combination of the barrier and accelerator looks favorable,” he said.

“However, in this particular case, clients and advisors need to look very closely at the 75% barrier, he added.

“A barrier is not as safe as a buffer. Under certain scenarios, this 75% barrier could nullify any benefits of this note.”

Pros

One of those benefits was the relatively good credit of the issuer.

“Counterparty risk should always be a consideration of structured note investors,” he said.

Another positive aspect was the valuation of the underlying asset class.

“Most overseas markets especially emerging markets have offered positive relative value to U.S. stocks for nearly the entirety of the historic bull run.

“The EEM ETF is already more than 20% off its highs, so the entry point looks relatively good at this time,” he said.

Volatility, long bull cycle

On the flip side, however, emerging markets always bring more risk to investors given their volatility and the unpredictability of geopolitical and macroeconomic events, which directly impact returns, he noted.

“Any investor in this asset class should be concerned about the risk. These concerns may be magnified by the high beta of emerging market issues, and the fact that this note is tied to a dollar-denominated ETF, adding currency risk to the equation. In addition, the next three years may pose an inflexion point in global markets after an extended bull market.

“This is why investors need to evaluate how comfortable they are with this barrier. A 25% price decline in the emerging markets space is not out of the ordinary,” he said.

“I think a buffer would be a much better option.”

Big drops

Steve Doucette, financial adviser at Proctor Financial, reached a similar conclusion. He suggested a possible tradeoff to allow for the more expensive buffer.

“As I look at it, I’d probably be more inclined to have a hard protection on this note,” he said.

Emerging markets are known for displaying wide price moves over short lapses of time, he added.

Just within its 52-week range, the MSCI Emerging Markets ETF saw a 28% drop between the high in January and the low in October.

Leverage versus buffer

At the same time, Doucette expects the ETF to recover from its lows in the three-year term, which does not necessarily mean the fund would end up positive.

“This has been the underperforming asset. It’s been down a lot. I’m not saying it will rally for three consecutive years, otherwise why bother with a buffer? But if it recovers, I would imagine it would come back pretty strong,” he said.

This raised the issue of leverage.

For Doucette the risk is more on the downside.

“The cap is reasonable. Who’s going to cry about 12% a year?” he said.

The cap range is the equivalent of an annualized compounded return comprised between 11.8% and 13.2%.

“How much leverage do I need? I’m capped at 12% a year. If the emerging markets rebound, I don’t need 1.5 times to get there. I might be capped out anyway.

“That’s why I’d look at reducing the leverage a bit to get a hard buffer.

“The question is: how much of a hard buffer? And at what point does the market turn? These are the tough questions that beg for a more solid protection on the downside.”

Wells Fargo Securities, LLC is the agent.

The notes will price on Nov. 29 and settle on Dec. 4.

The Cusip number is 78013XR42.

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