RBC's leveraged barrier notes linked to Euro Stoxx 50 offer alternative to direct equity play

By Emma Trincal

New York, Jan. 11 - Royal Bank of Canada's 0% bullish barrier enhanced return notes due Feb. 2, 2016 linked to the Euro Stoxx 50 index give investors a "decent alternative" to a direct investment in the equity equivalent such as an exchange-traded fund, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par plus 122% to 132% of any index gain, according to an FWP filing with the Securities and Exchange Commission. The exact leverage factor will be set at pricing.

Investors will receive par if the index falls by up to 30% and will be fully exposed to losses from the initial level if the index declines by more than 30%.

The final barrier protection and the uncapped leveraged upside were the two best features of the product, she said.

Dividends vs. leverage

"It's probably a longer maturity than a lot of leveraged products, which are often two years or under. But it's not that long. It's medium maturity," she said.

"That's probably why they can give you uncapped leverage. The longer the maturity, the closer you can get to headline terms. And then there is some slight leverage at a rate of 1.22 to 1.33."

The leverage is always a plus, but in the case of these notes, it may be justified first as a way to offset the absence of dividends an investor in the ETF would receive, she said.

"Investors have to forego dividends, so whether they can outperform the index or not depends on how much the index is going to grow," she said.

"It's one thing to get 100% participation and to forgo dividends, but with this deal, the slight leverage at least compensates you for not receiving dividends and you still may outperform the underlying, although it's not a guarantee."

The dividend yield on the Euro Stoxx ETF is 3.55%, which would be a 10.65% return over the three-year period from just collecting the dividends on the fund, she said.

In order for the notes to match this dividend yield, the index would need to grow by 2.73% a year, assuming a leverage factor of 130%. The break-even point would be a final return of 8.20% at the end of the three-year timeframe.

"It's not an unrealistic amount. If you go anywhere above, you're outperforming the index because the dividend yield is fixed and anything on top of that is pure alpha, delivered through leverage.

"Of course, there's always a chance that you may underperform the index. It's the kind of a trade-off that you have.

"If you invest directly into the ETF, there's no credit risk and you collect the dividends.

"With the notes, you're subject to the issuer's credit risk. But you do have the upside gearing and the downside barrier. Having a 30% contingent protection on the downside is a good advantage you wouldn't get with an ETF. So it's a fair trade-off," she said.

Bullish

The product, which also offers the advantage of being easy to understand, is designed for bulls, she noted.

"It's a growth product. You're not going to make a return unless the index is up. In that regard, it competes directly with an ETF. The investment could be used as part of your equity allocation. It's a pretty simple structure; you're not looking at a complicated volatility play," she said.

"Compared to an investment in the fund, all you're doing is slightly changing the risk/reward profile."

The product is geared toward the very bullish investor who values downside protection but not at the price of capping returns, she explained.

"You have no cap. It pays off if you're bullish. The leverage is quite moderate, but given the uncapped return, it's aimed more towards the bullish investor who looks for a high potential return," she said.

The risk associated with the notes is comparable to the average of the same product type, as measured by riskmap. Peer products would be all types of leveraged notes.

Riskmap is Future Value Consultants' indicator of the risk of a product on a scale of zero to 10 with 10 amounting to the greatest risk. The riskmap is the sum of two risk components: market risk and credit risk, which are measured on the same scale.

Two risks

There was more market risk associated with this product than credit risk, according to the scores.

"You would expect with a longer maturity a relatively high credit riskmap, which clearly is not the case here," she said.

The credit riskmap is 0.58, compared with 0.90 for the average leveraged note.

"Although it's longer, it's Royal Bank of Canada, one of the best credits out there.

"The five-year CDS spreads for the Canadian bank are only 52 basis points, much less than most banks as you can't find that many banks showing spreads under 100 basis points. You have JPMorgan at 82 basis points. But Bank of America's CDS spreads are 114 basis points and Morgan Stanley, 160," she said.

On the other hand, the market riskmap of 3.32 is greater than the 2.91 average, she noted.

"It's a combination of a longer maturity and a more volatile underlying," she explained.

"A lot of leverage notes are tied to the S&P 500, which has an implied volatility of 18, compared to 22% for the Euro Stoxx index. But also, most leverage products do not exceed a two-year duration. They're often shorter, in the one-year to 18-month range. So over three years, it can make a difference."

Overall, the lower credit riskmap tends to offset the more elevated market riskmap, giving the product a 3.90 riskmap versus 3.81 for similar structures.

"Investors should always take into account the two risk components when comparing products," she said.

"You could have a sound product that looks safe, but the issuer may not have such good creditworthiness, which could put you at a much higher risk level than you may realize."

High return

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The 8.34 return score associated with the notes is "much higher" than the average of 7.31 for all leveraged products, she said.

"We're using the high-growth scenario, and based on that, there's a high return potential because it's not capped and also because you've got three years to play with. This product can really do very well," Hampson said.

Based on the high-growth scenario, investors have an 86.4% chance of generating a profit at maturity versus 13.6% for losses.

Within the gains buckets, the odds of earning more than 15% per annum are 25.4%.

When using the neutral assumption, which is a risk-free growth scenario, the probabilities become 74.8% for profit against 25.2% for loss.

Price, overall

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes show a 7.44 price score, which is not much higher than the 7.32 average, although still slightly better.

"It's a good price score and one that's totally comparable to the average. Just because the returns score is greater than average doesn't necessary mean that the price score will be higher too. Giving investors the best value for the assets is one thing; how the notes actually perform is another," she said.

While investors want both the return score and the price score to be high, the price score is more of a neutral rating, she explained. Investors, however, should want the highest return score possible.

"What you don't want is a price score that's really below average. Here we're in the same ballpark. It doesn't give you any reason not to invest. You are in the average. That's fine. You're not getting ripped off," she said.

Future Value Consultants, with its overall score, offers its opinion on the quality of a deal. The score is simply the average of the price score and the return score.

The notes received a 7.89 overall score, better than the 7.31 average for comparable products.

Hampson pointed to a chart published by Future Value Consultants that plots a product based on its riskmap and overall score. The ideal position - on the top left corner - is to have the lowest riskmap and the highest overall score.

"It's above average. If you look at the chart, you'll see that yes it's slightly more risky, but it's well up there on the top of the overall score chart. You want the plot to be on the top left corner, but it's not going to happen. Being close to the top on the overall scale is pretty good," she said.

"This is a pretty competitive product that gives investors a good alternative to a direct investment in the fund."

The notes (Cusip: 78008SVE3) will price on Jan. 28 and settle on Jan. 31.

RBC Capital Markets, LLC is the agent.

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