RBC’s $1.91 million buffered notes tied to Euro Stoxx 50 show striking 10x leverage

By Emma Trincal

New York, June 25 – Royal Bank of Canada’s $1.91 million of 0% buffered leveraged notes due June 20, 2023 linked to the Euro Stoxx 50 index surprised market participants for the amount of leverage the issuer applied to enhance the upside.

The payout at maturity will be par plus 10 times any gain in the index, capped at par plus 85%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 15% and will lose 1% for each 1% decline beyond 15%.

Forwards

“This 10x leverage is very eye-catching and apparently the pricing worked. I guess the five-year forward with the cap is cheap enough to make it work,” a structurer said

The forward contract illustrates what the market expectations are for a specific asset at a specific future date. Its price derives from the relationship between interest rates and dividends.

When the dividend yield is high and interest rates are low, the forward contracts are cheap, making the cost of the call options used to purchase the leverage relatively inexpensive.

The Euro Stoxx 50 index has a higher yield at 2.55% than the S&P 500 index at 1.80%. In addition, government bonds pay negative (hence much lower) interest rates in Europe than in the United States. As a result, pricing is very competitive when using the Euro Stoxx 50 index as an underlying in a structured note, compared to the U.S. benchmark, he explained.

Five-year

Carl Kunhardt, wealth advisor at Quest Capital Management, at first said he did not like the five-year tenor given the global trade tensions, especially between the United States and Europe over tariffs.

“It looks like Trump is threatening Europe with more tariffs and nobody wins in a trade war...Europe in particular is not going to win that war,” he said.

But the note was “very attractive,” he noted.

“Every asset allocator needs European equity in his portfolio. So the question is: am I better off with this note than being long the index? In terms of the structure, yes, I am.

“This huge leverage allows me to get a double-digit return very easily. That coincides with my market outlook. I’m not particularly bullish on equity at this point. Our strategists predict returns of about 7% to 8% a year over the next few years. Cut it in half if we have a down market and here you have it.”

Small is big

Indeed, one of the advantages of high leverage is to allow investors to reach the cap with very small index increases, explained the structurer.

“With an 85% cap over five-year, the annualized compounded return is 13.10%,” he said.

“The amount of leverage reduces the amount of index growth necessary to reach the cap. With 10x, the Euro Stoxx only needs to rise by 1.65% a year in order to get to the maximum return. If the leverage was two times for instance, the annual return would have to be as high as 7.35% in order to cap out.”

Kunhardt said he would be more than comfortable with a 13% annual return given his modest return expectations on equity as an asset class for most markets worldwide.

“The cap is very decent and it’s not hard to get there,” he said.

“I don’t really like such a long note. But I appreciate the parameters of this deal, especially if you’re going to give me a 15% buffer at the end of the five years.

“It’s a little bit long, but it is what it is.”

Be unloved!

Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, on the contrary welcomed the longer duration. But he pointed to the high valuation of the underlying index.

“I’m always surprised by the timing of those notes,” he said.

“They always put together these products on something that’s already very popular. The Euro Stoxx is close to its high.

“Issuers should try to do the opposite, really. They should price deals on things that are not popular. It might be a different type of clients but they should try. You’d get much more value and I suppose better pricing.”

Kaplan’s investment style, as his firm’s name indicates, is contrarian. He looks for stocks and exchange-traded funds that go against the crowd and offer value.

Good length

Anticipating a correction short-term for most equity markets, Kaplan said he was comfortable with the length of the notes.

“At least if we have a recession we’ll have some time to recover from it. So I think the period of time is reasonable,” he said.

“You’re buying an index that’s at a high valuation level. But it’s not a two-year. The five-year interval gives me more confidence.

Cutting opportunity costs

Kaplan also noted the high leverage amount, which he said made the product all the more valuable because it eliminated some of the opportunity costs.

“You’re compensated for the dividends,” he said comparing the five-year Treasury yield of 2.75% with the dividend yield paid by the Euro Stoxx. “It’s not difficult now to find safe assets that pay more than dividends anyway. That’s precisely how we know the stock market is overpriced.”

The notes would naturally pay more than a five-year CD given that differences in risk. He took the example of a five-year CD at 3%, which would return 16%.

“You’re getting such a high return with the notes at 85%. It’s a lot more than 16%, making it worthwhile taking on the risk.

“By giving you all this leverage and such a cap, they’ve put together a pretty worthwhile structure, actually one of the most reasonable I’ve seen so far.”

RBC Capital Markets, LLC is the agent.

The notes (Cusip: 78013XLX4) priced on June 15.

The fee is 3%.

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