RBC’s trigger absolute return step notes linked to index basket designed to generate alpha

By Emma Trincal

New York, Feb. 14 – Royal Bank of Canada’s 0% trigger absolute return step securities due Feb. 29, 2024 linked to a basket of six indexes caught advisers’ attention as they offer various ways to outperform the underlying basket in different market scenarios.

The basket offers exposure to non-U.S. equity indexes in developed countries.

Its components are the Euro Stoxx 50 index with a 40% weight, the FTSE 100 index with a 20% weight, the Nikkei 225 index with a 20% weight, the Swiss Market index with a 7.5% weight, the S&P/ASX 200 index with a 7.5% weight and the Hang Seng index with a 5% weight, according to an FWP filing with the Securities and Exchange Commission.

If the final basket 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 basket return. The step return is expected to be 50% to 53% and will be set at pricing.

If the final basket 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 basket 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.

Beating the market

“If I look at it the way I typically look at notes – which is, am I going to outperform and by how much? – at first glance it looks pretty good,” said Steve Doucette, financial adviser at Proctor Financial.

“You almost want the market to go down 30%. With the absolute return that would give you a 30% gain, meaning you beat the market by 60 points. On the upside, the best excess return you can get is 50%.”

But these were just extreme scenarios. Overall, Doucette wanted to emphasize that the margin of possible excess returns over a long position in the basket was relatively wide.

He liked the 50% minimum return, which is a digital payout.

“If it’s up moderately, you get a boost with 50%. Let’s say it’s up only 5% a year. Your return will be twice that. That’s a lot,” he said.

The fact that the minimum return does not cap any gains was a plus as well.

“If it’s up more than 50%, you no longer outperform. You market perform. But at least you’re not penalized by a cap,” he said.

“It’s a note that gives you a decent way to get exposure without giving up the upside.

“It’s also well-protected on the downside with potential for significant outperformance.”

Revised

But Doucette said the notes may be improved.

“What would I do differently? I personally think that a 30% protection over five years ... I’m not sure makes sense,” he said.

“It’s true that we’ve had the longest economic and stock market expansion cycle. So within the next five years we’re definitely going to have a bear market.

“But a bear comes and goes.

“I would put more emphasis on the protection for a one- to three-year maturity, not for five years.”

Doucette added that “I don’t get too excited” about the absolute return component. His rationale was the same.

“You need to be down from zero to 30% to capture the benefit. Just like I don’t think you need much protection for a five year, I’m not sure the absolute benefit is going to be captured.”

Fear of missing out

Perhaps Doucette’s main risk consideration was a bear market occurring in the short run, leaving some time later for a strong rebound. In such scenario, the final return could exceed the 50% guaranteed level and investors would not benefit from the notes more than they would from a long position.

“The only thing that’s uncertain is time. But I’m quite optimistic that we will go through the down cycle and bounce back within the five-year timeframe,” he said.

In this case, a leveraged rather than a digital return would be a preferable option.

“I think I’d rather cut the barrier for a little bit of leverage in exchange,” he said.

A buffer is always better but tends to price poorly when combined with an absolute return payout, he noted.

Instead, he would be willing to lower the barrier protection from 30% to 20% while keeping the absolute return.

Another requirement would be to leave the upside uncapped.

The odds of outperforming with his revised structure would be greater, he said.

The notes as they are offer 80 points of potential outperformance between negative 30% and positive 50%.

Doucette acknowledged that it was a wide range but he argued that it was one that may not be “captured.”

With the leveraged structure, investors would only lose principal if the basket declined by more than 20% after five years, which he said is unlikely. They would “win” in all other scenarios.

Another potential change would be in the basket composition.

The basket allocates 67.5% to European stocks, including the euro zone, the United Kingdom and Switzerland.

Japan is the second largest region with 20% of the holdings followed by 12.5% for Australia and Hong Kong.

“If I was doing this note, I would probably be adding emerging markets. They’ve gone down harder over the past few years. Europe hasn’t done much,” he said.

Alternative exposure

Matt Medeiros, president and chief executive at the Institute for Wealth Management, said the notes could offer an interesting exposure to the asset class, which would fit with his firm’s outlook.

“We’ve heavily underweighted these indices. Although they do have attractive valuations at the moment, many of these zones are facing big headwinds,” he said.

Faced with this dilemma of wanting to take advantage of relatively cheap assets versus U.S. stocks without incurring too much geopolitical risk, the notes may offer a solution.

“We’d like to assume that in the next five years, Europe will offer some opportunities. Considering the low value of these indices, the notes may be an interesting way to get exposure to these areas with some protection.”

The digital payout offered a chance to outperform if the underlying basket was trading range-bound.

The uncapped return would not disrupt a bullish outcome.

“It’s hard to predict that far out. But considering our underweight position, the digital would be a big help. If we’re wrong to remain somewhat bullish for this five-year timeframe, the absolute return is also an attractive feature.”

UBS Financial Services Inc. is the agent.

The notes (Cusip: 78014H276) will price on Feb. 26 and settle on Feb. 28.

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