RBC’s $14.33 million trigger gears on basket of five indexes offer strong growth potential

By Emma Trincal

New York, Sept. 26 – Royal Bank of Canada’s $14.33 million of 0% trigger gears due Sept. 23, 2027 linked to an unequally weighted basket of international indexes offer a concentrated exposure to developed markets with aggressive growth potential given the upside payout, advisers said.

The basket consists of Euro Stoxx 50 index with a 40% weight, the Nikkei 225 index with a 25% weight, the FTSE 100 index with a 17.5% weight, the Swiss Market index with a 10% weight, the S&P/ASX 200 index with a 7.5% weight, according to a 424B2 filing with the Securities and Exchange Commission.

If the basket return is positive, the payout at maturity will be par plus 2.02 times the basket return.

Investors will receive par if the basket declines by 25% or less and will be fully exposed to the basket’s decline from its initial level if it declines by more than 25%.

On the plus side

Carl Kunhardt, wealth advisor at Quest Capital Management, said he liked the structure.

“There are more pluses than minuses,” he said.

“You’re exposed to a basket. I like that. It’s not a worst-of.

“You have exposure to developed markets. I like that too for an international equity allocation because right now, I’m not big on emerging markets.

“The fact that there is no cap and that you get a 25% barrier is a plus too. It’s not as nice as having a buffer but the 75% barrier over five years is pretty good.

“There are no call features. That’s another advantage.

“All that is stacking up on the positive sign.”

Global equities

Among the negative aspects of the deal, he pointed to the tenor and the opportunity cost associated with missing high-dividend yields.

“It’s five-year. That’s kind of long for a note,” he said.

“You don’t get paid any dividend and global markets pay bigger dividends.”

The basket could easily be compared with the MSCI EAFE index and its corresponding ETF –the MSCI EAFE ETF, listed under the ticker “EFA,” he noted.

The MSCI EAFE index tracks the performance of developed markets in Europe, Australia, Asia, and the Far East.

“You’re definitely removing the emerging markets component, which is fine with me, and you’re getting pure exposure to developed markets ex-North America,” he said.

War zone

While the basket is diversified across five countries, the concentration around European stocks was significant, he noted, making for about two-thirds of the basket, including non-euro zone members such as the U.K and Switzerland.

The same concentration holds true for the MSCI EAFE index and ETF.

“When you think developed markets outside of the U.S., Europe is what comes out. But right now, it’s a little bit of a wildcard. I’m not a big fan of Europe because there is a war in Europe,” he said.

“Putin could cut his losses and back off. That would be the only way to end this war. Like we said at the U.N. last week: if Russia stops fighting, there will be no war. If Ukraine stops fighting, there will be no Ukraine.”

“Obviously Russia is losing. But are they going to end this war? We have no way to tell.

“For the past hundreds of years, the world has constantly had to have a war in Europe. Everything is a war in Europe.

“War is always problematic for the markets because the markets hate uncertainty. Until this war is settled, European markets are going to be very volatile.

“This is probably the most concerning aspect of this note.”

EAFE-like

A financial adviser said he liked the note. He ran some back testing on the MSCI EAFE ETF, which he said had very similar characteristics to the basket. He concluded that the notes offered a high probability of “beating” the ETF return.

“I like the longer tenor because that’s how you get better terms. You’re not going to get uncapped returns on an 18-month,” this financial adviser said.

He compared the country weights in the iShares MSCI EAFE ETF with the composition of the underlying basket and found a strong correlation between the two assets.

“It’s basically the same thing except for some countries in the Asian-Pacific region that are not part of the basket,” he said.

The ETF, he noted, allocated 41% to several member-countries of the euro zone, such as France, Germany, Denmark, Spain, Italy, Germany and the Netherlands, a proxy for the Euro Stoxx 50 index, which itself has a 40% weight in the underlying basket.

Japanese equities represented 23.46% of the ETF and 25% of the basket. The FTSE 100 index accounted for 15.12% of the ETF versus 17.5% of the basket. The weights for Switzerland and Australia were also very similar, he said.

“It’s the EAFE in another name,” he said.

The only countries in the ETF that were not part of the basket were Hong Kong, Singapore, New Zealand, and Israel, he said.

Encouraging probabilities

“I like the structure of the notes. But I’m not sure why they wouldn’t use the EFA,” he said.

This adviser said that he has collected data on the iShares MSCI EAFE ETF for the past 20 years.

“The ETF and the basket have to be highly correlated, so I feel comfortable running my analysis on the ETF,” he said.

Looking at five-year rolling periods, he found that the fund breached the barrier (decline of more than 25%) only 1.8% of the time.

“The barrier is more than decent. I’d rather have that 25% barrier than a 10% buffer quite frankly because the chances of losing money with this barrier are exceptionally low,” he said.

Getting a positive return was “not all that difficult,” he noted. His data showed a frequency for positive returns 84% of the time.

“That leaves you with a chance of approximately 14% of getting your money back with no return,” he said referring to any final negative return above barrier level.

Leverage, dividends

One of the reasons the two-times leverage exposure was helpful was because international markets tend to pay more dividends but display less growth than domestic markets, he said.

The 30-day SEC yield for the EAFE ETF is 2.56% versus 1.63% for the S&P 500 index.

“By virtue of investing in the notes, you’re losing almost one percentage point in income, which is significant because you’re not going to get as much growth,” he said.

“U.S. returns are based on a little bit of income and on a lot of growth. International markets are producing more dividends and less growth,” he said.

During most five-year periods, the EAFE ETF lagged the S&P 500 index. One notable exception was between January 2002 and January 2007, he said, when the S&P 500 index declined by 22.8% and the EAFE ETF doubled in price.

“It’s a very good thing to have that much leverage. With 2 times, you are going to more than offset the loss of dividends,” he said.

FX factor

Another possible driver for gains would be a reversal in the performance of the U.S. dollar against other currencies.

“The dollar has been very strong so far, which made international stocks look worse because you get fewer dollars when the funds are converted into dollars.

“But if the dollar begins to fall – and it should at some point –investors in foreign stocks will be able to take advantage of the exchange rate and get higher returns.”

Looking at different buckets from his data, the most likely return outcome was a 20% to 40% gain over a five-year rolling period.

“The nice thing with the 2x leverage is that now we’re talking about a 40% to 80% return on a five-year term, which is really nice,” he said.

Fee

This adviser said his only “complaint” about the deal was its cost – a 3.5% fee as stated in the prospectus.

“That seems to be very high relative to what I see out there. Even if you spread that cost over five years, it’s still 70 basis points per annum. A few years ago, 70 bps per annum would have been very competitive. But fees have dropped all across the board. Today, 70 bps a year is a bit high,” he said.

Usually high-fee products do not yield the best terms. But this note was an exception, he said.

“The terms are there. The leverage is exceptionally good. It’s uncapped. The barrier gives you enough downside protection to be able to sleep at night.

“This note gives you a chance to outperform both the international and maybe the domestic markets.

“I really like it,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

RBC Capital Markets, LLC is the agent, and UBS Financial Services Inc. is the placement agent.

The notes settled on Thursday.

The Cusip number is 78016D513.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.