RBC’s planned autocall contingent coupon notes on Ford, GM may pay higher yield for longer

By Emma Trincal

New York, May 12 – Royal Bank of Canada’s autocallable contingent coupon barrier notes due May 23, 2019 linked to the lesser performing of the common stocks of Ford Motor Co. and General Motors Corp. are designed to maximize the chances and the length of earning contingent income, said Suzi Hampson, structured products analyst at Future Value Consultants. But for all that, the risk of not being called and therefore losing money looms at maturity.

The notes will pay a quarterly coupon at an annual rate of 8.5% to 9.5% if each stock closes at or above its coupon barrier, 65% of its initial level, on the review date for that quarter, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par plus the coupon if each stock closes at or above its initial price on a review date starting on Nov. 20, 2017.

The payout at maturity will be par plus the final coupon unless either stock finishes below its 65% trigger level, in which case investors will lose 1% for each 1% that the lesser-performing stock’s final level is less than its initial level.

Yield-enhancement

“These are common products. They have somewhat replaced the traditional reverse convertible which used to pay a fixed coupon and was tied to only one stock,” said Hampson.

Current volatility and rate levels no longer facilitate the pricing of fixed-rate products, she explained.

“This one has a contingent coupon and a worst of, allowing the issuer to offer a higher headline rate.

“It also gives you a quite reasonable barrier.

“But there is more risk than in similar notes that have recently priced.”

First, the notes are not linked to indexes but to single stocks. Secondly, the two stocks, while in the same sector, are not highly correlated, she said.

The correlation between General Motors and Ford is 75%.

In comparison the S&P 500 index and Russell 2000 index, a pair issuers routinely employ in worst of products show a correlation of 90%.

“The low correlation and the use of two stocks in the worst of significantly increase the risk compared to worst of linked to two U.S. equity indexes,” she said.

Risk profile

A stress-test report created by Future Value Consultants for this product suggested a higher level of risk commensurate with a higher-yielding and more achievable source of income.

The notes are not easily called compared to other products, she said, which is partly due to the low correlation between the two underliers.

As a result and given the low barrier level, investors may earn the coupon over a longer period, she said.

But the risk of “heavy losses” at maturity is greater.

First date

One of the report’s tables called “product specific tests,” points to a quasi-certainty of receiving some income at some point in time: the probability of never getting paid any coupon is a tiny 0.09%. Probabilities of being paid were closely related to the odds of an autocallable event to occur.

The probability of getting called on the first “call point,” was much lower than the average for similar products, she said.

“It is a common characteristic for all autocallables to display the highest probability of a kick out on the first call point,” she said.

For this product, the first call date is six months after the initial pricing date.

“Chances of calling at that point are only 35%. We’ve seen much higher than that,” she said.

She referred to a recently priced contingent autocallable note with quasi-similar terms, including a six-month no-call but tied to two U.S. equity indexes. This product, which priced a week ago, had a probability of being called on the first call date of 48%.

“What we have here is a lot lower,” she said.

“If you get called on that first date, you get your two coupons,” she said, explaining why the 35% probability associated with the payment of only two coupons was the same as the one for the first call.

On the other end of the spectrum collecting all eight coupons without ever being called was an outcome that happened 13% of the time.

“This is your optimal scenario and the probability of achieving it is quite high,” she said.

Make or break

If the notes are not called, investors may be receiving the full payment. Another possibility, which has a 20.1% chance of happening, is that the barrier breached at maturity, which automatically generates a principal loss of at least 35%.

Another table called the “scorecard” shows that the average loss associated with the “loss of principal” outcome is 44.5%.

This payout takes into account the probabilities and amounts of coupon paid.

“This shows you that while you have a good chance of earning well above the risk-free rate, the odds of losing money and the amount of losses you may incur are quite substantial,” she said.

RBC Capital Markets, LLC is the agent.

The notes will price on May 19 and settle on May 24.

The Cusip number is 78012KR33.

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