RBC’s trigger autocalls on energy, financial ETF basket offer timely play on recovery

By Emma Trincal

New York, March 26 – Royal Bank of Canada’s 0% trigger autocallable contingent yield notes due March 20, 2023 linked to a basket of two equally weighted exchange-traded funds are designed to bet on a return to a normalized economy with the basket comprised of two top performing sectors, said Clemens Kownatzki, finance professor at Pepperdine University.

The basket consists of the Energy Select Sector SPDR fund and the Financial Select Sector SPDR fund, according to an FWP filing with the Securities and Exchange Commission.

Each quarter, the notes will pay a contingent coupon at the rate of 10% to 10.8% per annum if the basket closes at or above the coupon barrier, 75% of the initial level, on the observation date for that quarter.

The exact coupon rate will be set at pricing.

The notes will be automatically called at par of $10 if the basket closes at or above the initial level on any quarterly observation date after six months.

If the notes are not called and the final level is greater than or equal to the downside threshold level, 75% of the initial level, the payout at maturity will be par. Otherwise, investors will lose 1% for every 1% that the final basket level is less than the initial level.

Financial stocks

“This is the rotation into value that we’ve seen since the end of last year. It’s the higher-inflation, higher-yields kind of strategy,” said Kownatzki.

“We know that rising yields are a good thing for financial institutions although there’s a caveat here.”

He pointed to the components of the Financial Select Sector ETF.

“It’s a well-diversified fund, but it’s not a pure financial play...you have Berkshire Hathaway with less than 13% and BlackRock Inc. with about 3% and those are holding companies, not pure financial institutions,” he said.

“They’re more value plays. You have to consider whether they’ll do better in a booming economy.

But for the most part, the fund was well positioned to benefit from a recovering economy.

Financial stocks are the second best-performing sector in the United States.

The Financial Select ETF is up 18.5% year to date.

Bank’s P&L

“Banks make money by borrowing low and lending high. That’s why the steepening of the curve is a good thing for them,” he said.

While the Treasury market was quiet last week with the 10-year Treasury yield down to 1.67% from a recent high of 1.73% on the previous week, long-term rates have increased by more than 76 basis points since the beginning of January.

Meanwhile, on the short end of the curve, the Federal Reserve suggested that it will not lift rates until at least 2023.

“The curve is steeper. It’s a good environment for banks’ profitability,” he said.

Some banks enjoyed a boost on Friday after the Fed announced that it will lift restrictions on dividends and share repurchases after completion of the current round of stress tests.

Bank of America Corp. was up 2.7% and Citigroup Inc. rose 1.8% on the day.

Concentrated energy

Kownatzki was also relatively optimistic about energy, which is the top-performing sector as countries have slowly started reopening their borders and states, their economies.

“There’s also a small caveat to this fund. It’s a highly concentrated portfolio,” he said.

The fund only has 23 components. Its top 10 holdings represent nearly 80% of the total.

Exxon Mobil Corp., Chevron Corp. and EOG Resources Inc., which are the top three, have a combined weighting of more than 50%.

“This concentration obviously adds more risk,” he said.

But so far, energy is the best-performing sector in the economy, with the Energy Select Sector SPDR fund up 30% for the year.

Some risks

“The notes are really a play on a slightly better economy. In a post-pandemic environment, there will be pent-up demand for travel. People have saved money and they probably will want to spend it. As more people get vaccinated, demand for airlines, hotels, travel in general will be surging,” he said.

For investors betting on oil stocks, the difficulty in predicting geopolitical events is one of the worst challenges, he said.

“Look at the recent blockage in the Suez Canal. These are not things you can anticipate, and they can impact oil prices significantly,” he said.

Another risk factor is the push for clean and renewable energy as concerns about fossil fuels are rising.

The popularity of electric car maker Tesla Inc. is partly the result of investors “embracing the idea of reducing dependance on oil.”

But Kownatzki said the risk is not immediate.

“Market participants are starting to realize the craze about electric vehicles is a little bit overdone,” he said.

“You can’t replace all cars with electric vehicles overnight. It’s going to take some time. There’s a slower realization that we still need oil. Millions of cars are still there. We can’t make them disappear.

“Long-term renewable energies will have an impact on crude oil prices. But for a two-year note, it’s not really relevant.”

Likely call

For investors seeking high yield over a short period of time, the notes offered an attractive proposal.

“I think the 75% threshold gives you a fair amount of wiggle room. It’s a good cushion,” he said.

“The notes are likely to be called in six months, and the call is not a bad feature.”

Having the notes tied to a diversified basket of funds rather than a worst of two ETFs was another advantage for investors.

Finally, both sectors should continue to post solid returns as signs continue to emerge that the pandemic is coming to an end.

Since the end of October, the Energy Select Sector ETF and the Financial Select Sector have gained 80% and 40%, respectively.

“From my perspective, it’s a recognition by the market that we’re at a turning point and that the economy is recovering.”

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

The notes were expected to price on Friday and settle on March 31.

The Cusip number is 78014M739.

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