RBC’s 8% STEP Income Securities tied to Facebook offer fixed rate on big recovery story

By Emma Trincal

New York, July 18 – Royal Bank of Canada plans to price 8% STEP Income Securities due August 2019 linked to the common stock of Facebook, Inc. provide investors with a guaranteed coupon and perhaps more fixed payout at maturity.

The 8% interest is payable quarterly, according to an FWP filing with the Securities and Exchange Commission.

If the final price of Facebook stock is greater than or equal to the step level, 108% of the initial share price, the payout at maturity will be par of $10 plus the step payment, which is expected to be 1% to 5% and will be set at pricing.

If the final share price is greater than or equal to the initial share price but less than the step level, investors will receive par.

If the final share price is less than the initial share price, investors will be fully exposed to the decline.

Revcon 2.0

“It’s a very specific view. You have to look at the price action. For people who are bullish but prefer getting a coupon, that’s a play similar to a reverse convertible,” a market participant said.

Reverse convertibles are short-term notes with a high coupon obtained through the sale of an embedded put option. The more volatile the stock is, the higher the potential return.

Investors however limit their upside to the coupon.

In this case, the STEP Income payout, which is a Merrill Lynch brand name, allows investors to earn the fixed 8% return plus a potential bonus whose final value remains unknown until pricing. In the best-case scenario, if the stock finishes above the step level, investors can collect up to 13% based on a 5% step payment.

“You get the fixed 8% plus another coupon, but that last one is not guaranteed,” the market participant said.

“It’s interesting. The product is tweaked to make it more than a classic reverse convertible. It makes it unique.

“I would say it’s reverse convertible 2.0.”

Sharp rebound

Facebook is one of the popular, high-performing “FANG” stocks. The acronym stands for “Facebook, Amazon, Netflix and Google.

A risk for investors could be to miss a substantial amount of growth as the stock can move up drastically.

But most reverse convertible buyers agree to this tradeoff for the safety of the return.

“They’re either not overly bullish or they need the income,” said a source.

Besides, when a stock moves as fast and much as Facebook in both directions, the overall return may not be as bullish at the end of one year.

“If you look at Facebook, it hasn’t always been going up,” the market participant said.

Facebook’s share price is up 15.5% for the year. This performance is the result of a sharp rebound after a drastic fall late March when news reports revealed a data leaking scandal.

At the end of the first quarter, the stock had lost 17% of its value since the beginning of the year. It rose rapidly just after the testimony of the company’s CEO before Congress at the end of March, falling just shortly toward the end of April then moving up with nearly no interruption in the uptrend.

Trading at $209.36, the stock since its low in March has soared 38% to an all-time high on Tuesday, staging an impressive recovery.

For income investors

“I’d be comfortable showing it. For someone comfortable with the risk, it’s a good way to get a high coupon from a fairly volatile stock,” an industry source said.

“If the market is flat, you do well.

“If the market is up, it’s just an opportunity cost.”

What about the risk?

Investors who buy these types of notes are typically income-seekers who are familiar with ways to generate income, he said.

“Many would do a worst-of on FANG stocks in order to get a return that would be more in the teens. But in that case, your coupon would be contingent and you would be exposed to correlation. It’s not necessarily a safer solution.”

Another factor that may reduce the risk of the trade is diversification across similar stock-linked products.

“A lot of people are not going to just do that note. They’re doing a lot of other notes on other stocks. You invest in those products as part of an overall portfolio. You diversify,” he said.

BofA Merrill Lynch is the agent.

The notes will price in July and settle in August.

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