RBC’s $15.46 million leveraged notes on index basket offer long-term European, U.S. exposure

By Emma Trincal

New York, Aug. 5 – Royal Bank of Canada’s $15.46 million of 0% geared buffered return notes due Aug. 6, 2026 linked to a basket of equity indexes give investors equal access to the domestic and European markets along with buffered protection and uncapped leveraged upside. Investors however need to be comfortable with the five-year holding period, advisers said.

The basket is made up of the S&P 500 index (50% weight), the Euro Stoxx 50 index (25% weight) and the FTSE 100 index (25% weight), according to a 424B2 filing with the Securities and Exchange Commission.

If the basket finishes at or above its initial level, the payout at maturity will be par plus 112% of the basket gain.

If the basket falls by up to 20%, the payout will be par.

Otherwise, investors will lose 1.25% for each 1% basket decline beyond the 20% buffer.

European value

Steve Doucette, financial adviser at Proctor Financial, said he liked the underlying.

“I like the basket better than the worst-of when it comes to index exposure,” he said.

“European stocks still haven’t done as well as U.S. stocks. So, if there’s a reversion to the mean between these two, you will benefit from it, which wouldn’t be the case with a worst-of.

“The U.S. could go down. Europe could go up. This basket is 50/50. At least you’re not going to be tied to the laggard.”

The basket is not a “global equity play,” he noted since the only non-U.S. assets are European stocks.

“But at least, you’re covering the Western Europe region with the eurozone and the U.K. without any overlap between the two,” he said.

Beating the market

The notes fit his main criterion, which is to provide a better alternative to a long position.

“We never know what direction we’re going to go for the next five years,” he said.

“But with 1.12 times the return, you’re going to outperform on the upside.

“If you get caught down, you’re still going to outperform because of the buffer. Even with a gearing you’ll still be ahead.”

The 1.25 multiple is calculated to place 100% of principal at risk.

But investors in the notes short of a 100% decline in the underlying will still be outperforming a long position in the basket. Dividend payments are not considered. The average weighted dividend yield of the basket is about 2%.

Even a 99% decline in the basket price would make the note outperform the long position by 25 basis points, he noted.

Good cap, bad cap

“So, while we don’t know where we’ll be five years from now, we do know that we have the potential to outperform on both ends. I kind of like that,” he said.

The absence of a cap was not a meaningful advantage in his view. Uncapped returns are best suited for aggressively bullish investors.

“If the market peaks, I don’t really care about having no cap,” he said.

“I’d rather have a cap actually... something like 10% to 12% a year with a little bit more leverage.”

Choosing the right tenor is always a challenge, he added.

Reward of patience

“The five-year is okay although we always like to keep it shorter,” he said.

“You could be sitting on a four- or five-year note with a 3% return at the end. Even with a lot of leverage, it wouldn’t do you any good.”

Doucette said he likes to keep his notes shorter in case he decides to reallocate the proceeds at maturity.

“We can always sell the note. We’ve done that. But it may not be the best option if the market is down or flat.”

On the other hand, a shorter tenor would not offer such attractive terms, he said.

“Duration is always a tough call.”

The longer maturity in this note allowed for the leverage and large buffer, a combination that issuers may not be able to price on a short-term product, especially in the absence of a cap, he said.

“We like the 20% buffer. The gearing is just there to improve the terms,” he said.

“Again, you never know in five years. We could run three more years then crash with a 40% drop.

“I may look at increasing the buffer or the leverage even if it means putting a cap on it. You can’t be too greedy. The market is already sky-high.”

Term, underlying

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he liked the duration and the underlying basket.

“I like that it’s five-year. I’m more comfortable with longer notes,” he said.

“The valuations are pretty high in the current domestic market, but it doesn’t appear that investors are really taking that into consideration. Even in Europe,” he added.

“That’s why it’s nice to have that 20% buffer. It’s a very attractive size.”

The current market uptrend could continue for some time, he noted.

“It’s a good idea to have an equal allocation to the U.S. and to Europe.

“Right now, neither one of these two markets are trading at a bargain even though nothing compares to the U.S. in terms of high valuations. But we’ve seen that some markets trading at high levels can still continue to appreciate.”

Return enhancement

If the bull market begins to slow, the leverage is a helpful way to position a portfolio for a lower return environment, he said.

“I like the 1.12 times leverage especially when you have moderate return expectations. Any return enhancement is a plus in this environment, especially with a long-term note,” he said.

“Some may want to see more leverage, especially if they have a range-bound view on the market.

But it would be looking in a crystal ball. And if you increase the leverage, chances are there would be a give somewhere either on putting a cap or offering less of a buffer.

“I like the structure as it is.

“The note is an attractive component as a core allocation in a portfolio.”

RBC Capital Markets, LLC is the underwriter.

The notes settled on Thursday.

The Cusip number is 78016ESH1.

The fee is 2%.

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