RBC’s trigger absolute return step notes tied to Euro Stoxx 50 seen as value play

By Emma Trincal

New York, April 26 – Royal Bank of Canada’s 0% trigger absolute return step securities due April 28, 2023 linked to the Euro Stoxx 50 index offer a range of possibilities for investors looking for exposure to the euro zone benchmark seen as offering better value than U.S. equity markets, advisers said.

If the final index level is greater than or equal to the initial level, the payout at maturity will be par of $10 plus the greater of the step return and the index return. The step return is expected to be 52.2% to 57.2% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the final index level is less than the initial level but greater than or equal to the downside threshold level, 70% of the initial level, the payout will be par plus the absolute value of the index return.

If the final level is less than the downside threshold level, investors will lose 1% for every 1% that the final level is less than the initial level.

Steven Foldes, vice-chairman of Evensky & Katz / Foldes Financial Wealth Management, said he liked the upside potential and would work with the issuer to enhance it.

“That’s an interesting note. There are things I like a lot and others that I don’t like. We would modify some of the terms of this product,” he said.

Valuation

The main “negative” aspect of the structure was the length of the investment horizon.

“We have a problem with the five-year term. It’s too long for us. This would be a non-starter,” he said.

On the other hand, he said he likes the underlying index.

“The Euro Stoxx has been lagging the S&P for several years,” he noted.

In the past 10 years including 2008, the Euro Stoxx 50 index has outperformed the S&P 500 index only three times: in 2009, 2012 and 2017, according to Morningstar.

“Valuations in the Euro Stoxx are more attractive than domestic valuations,” he said.

“Therefore, we want to participate in the upside. We see potential for growth. That’s why we like the digital as well as the uncapped upside above it. These are things we like a lot.”

Barrier

Because of his bullish outlook, Foldes was not particularly interested in the conservative structure on the downside, which offers not only contingent protection but absolute return up to a 30% decline.

“If you go out five years that amount of protection is not necessary. The likelihood that a drop of more than 30% would happen in five years is quite remote.

“Instead, we would want to enhance the upside and more importantly reduce the term of the note,” he said.

In his conversations with issuers, Foldes would negotiate. His main objective would be to cut the tenor by half or more. In exchange he would be willing to lessen the downside protection. The absolute return feature could be abandoned altogether.

Shortening it

“We know that a five-year maturity gives the issuer the ability to do more. They’re taking out more dividends. Going two or three years would limit our options. We know it would be a challenge,” he said.

But in exchange for a two- to three-year term, Foldes said that he would agree to less downside protection.

“How much less would depend on the terms we get on the upside,” he said.

“We definitely want to maintain the uncapped performance above the minimum return. We would also inquire to see if there is a possibility of getting some leverage above the digital as opposed to just one-to-one.”

Foldes realized that he may have to give up the entire downside protection to achieve those goals. The digital or step payment would also have to be less on an annualized basis.

Negotiating the terms

He described the foundation of the “rebuilt” structure as follows: a two-year note on the Euro Stoxx 50 index with a minimum return and uncapped exposure above the guaranteed return on the upside; the downside would probably have to be fully exposed.

“We would have to see what type of digital coupon we would get and if they’re willing to give us any leverage,” he said.

Giving up the downside protection and the absolute return would fit Foldes ’bullish view and would not represent a major concession. But it should help pricing better terms on the upside, he explained.

At the core, the combination of a minimum return with uncapped upside would have to be maintained.

“This is what makes this deal interesting. It wouldn’t be negotiable,” he said.

Favorable risk-return

Jeff Pietsch, head of capital markets at the Institute for Wealth Management, said he considers the Euro Stoxx 50 index as strategic value investment.

“We’re bullish on the Euro Stoxx 50, an index that has underperformed the S&P 500 since the Great recession,” he said.

“There’s a good chance that the euro zone benchmark will revert to the upside. We certainly wouldn’t expect it to fall down as hard as the S&P should we have a correction or even a bear market.”

“We think the risk/return on this note is pretty good although we’re not fans of long maturities.”

Good support

Looking at market risk, first, Pietsch said that current valuations for the euro zone benchmark offered a margin of safety.

“You’d have to be pretty bearish to think the Euro Stoxx could breach the 30% threshold. It would have to fall below the lows of 2009,” he said.

“My premise is that there will be a strong price support above the barrier level of the notes even in a very negative market environment.”

The credit risk exposure was to be taken into account as well, especially with a five-year tenor. Royal Bank of Canada has an A1 rating from Moody’s Investors Service and AA- from S&P Global Ratings.

“RBC is a decent underwriter. We can check that box,” he said.

Competitive upside

The structure was appealing on the upside in two ways.

“We like the guaranteed return on the upside. It fits our bullish outlook but it also fits the realistic view that returns may not be as great as they have been in the last 10 years,” he said.

The minimum return assuming a pricing in the middle of the range would be 9.1% on an annualized compounded basis, he noted.

“That’s your total return. But net of the current dividend yield, you’re looking around 6.5% to 7% depending on where the pricing ends up,” he said based on the 2.5% dividend yield of the underlying index.

“We see the Euro Stoxx as a value play. If it goes up above the minimum return, you get a chance to participate in its growth without a cap. If it shows only a moderate return, which is expected in the equity markets overall, you’re going to outperform thanks to the boost offered by the digital.”

Pricing, risk control

These aspects of the product made for an attractive risk-adjusted return, he added. However, he was disappointed by the cost of the notes, which carries a 3.5% fee, according to the prospectus.

“The only thing is the pricing of 70 basis points a year. I’d like to see half of that,” he said.

Turning back to risk mitigation again, Pietsch said that relying on current market valuations of the index along with the depth of the barrier were part of an overall risk control strategy. It was not sufficient however to justify an investment decision.

“As with any structured note, you have to be mindful about risk management. We do that by staggering the terms, creating a laddered portfolio of multiple notes. On the credit side, we strive to diversify across multiple underwriters.”

RBC Capital Markets Corp. and UBS Financial Services Inc. are the agents.

The notes (Cusip: 78013Q632) will settle on Monday.

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