RBC’s gears on index basket to be used for international exposure, diversification

By Emma Trincal

New York, Dec. 18 – Royal Bank of Canada’s 0% trigger gears due Dec. 19, 2028 linked to a basket of five indexes are designed to help investors diversify away from the United States through unlimited upside exposure and barrier protection.

The basket consists of the 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 an 10% weight and the S&P/ASX 200 index with a 7.5% weight, according to an FWP filing with the Securities and Exchange Commission.

If the basket return is positive, the payout at maturity will be par plus 227% to 237% of the basket return. The exact participation rate will be set at pricing.

If the basket finishes at or above its 75% barrier level, the payout at maturity will be par.

Otherwise, investors will be fully exposed to the basket decline.

EAFE replication

“I like the concept of the notes. It gives you a nice international exposure,” said Steve Doucette, financial adviser at Proctor Financial.

“Baskets are much more conservative than a worst-of. I like them. The only thing I like even more are those “best-of.”

Best-of, sometimes called “performance allocators,” provide at maturity a weighted return based on each components’ performance. The greatest weighting is given to the best performing component and the lowest weighting, to the worst performer.

Doucette said that he would have to study each index in the basket and review their respective weighting before making a decision.

The basket mirrored the EAFE index, he said.

The EAFE index tracks developed countries ex-North America, providing exposure to a broad range of companies in Europe, Australia, Asia, and the Far East.

“I would have to do my due diligence first,” he said.

“For example, Japan is through the roof right now. Do you really want Japan in your basket?”

Japan vs. India

The structure was appealing especially on the upside.

“I like the 2.3x leverage, no cap.”

The 75% barrier may have to be revisited.

“How much protection do I need on a five-year note? I would question if I need any,” he said.

The basket tracks the main developed markets, giving investors access to a unique asset class. Doucette said he would seek to enlarge the exposure to other countries.

“I would look at an emerging market, India for instance. That way you can get a little bit more volatility. Europe has been underperforming for many years. Are they going to catch up?”

When assessing a note, Doucette often will change some of the terms but may also modify the underlying.

“I like to modify the basket index components when modeling that kind of note.”

Changes on a basket can be easily made by modifying the weightings, adding or subtracting some of the components.

“I would really consider adding a small emerging markets exposure to this developed market basket. Replacing Japan with India makes sense to me.

“Once you study the asset class, you can make the necessary adjustments.

“This is a nice note. I like the upside. I’m not sure I would keep the 75% barrier though.”

Diversification tool

A financial adviser also liked the upside payout.

“There’s a significant amount of leverage in this note, which is what makes it really attractive,” he said.

The leverage should help offset the non-payment of dividends, he added.

“The lower the return, the higher the percentage of gains coming from the dividends. That’s how the 2.3 times boost comes really handy,” he said.

As an example, the Euro Stoxx index, which has the greatest weighting in the basket, pays a 3.21% dividend yield compared to 1.5% for the S&P 500 index.

This adviser viewed the downside protection as secondary.

“It’s probably not terribly likely that this international basket would be down more than 25% from its starting point.

“I always prefer a buffer to a barrier although the 25% protection is pretty solid.”

But the protection was not what caught his attention.

“You’re looking at a five-year term. A barrier is nice. But when you buy this note you expect the market to be up five years from now.

“The leverage and not having the cap is what makes the note interesting,” he said.

As structured, purely bullish investors may not find the note to match their view.

“If you’re really aggressive, you’re not worried about the downside. You would probably want more leverage instead,” he said.

The note could be a useful tool for financial advisers trying to encourage their clients to diversify away from the domestic market.

“The U.S. has outperformed so strongly that a lot of investors have shied away from international exposure.

“This is a good way to motivate people to invest in international equity while still giving them a security blanket.”

Otherwise, investors will be fully exposed to the basket decline.

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

The notes were expected to price on Dec. 15 and to settle on Dec. 19.

The Cusip number is 78016R207.

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