RBC’s trigger step notes linked to S&P 500 offer boost with uncapped upside, absolute return

By Emma Trincal

New York, Aug. 26 – Royal Bank of Canada’s 0% trigger absolute return step securities due Aug. 30, 2024 linked to the S&P 500 index offer absolute return on the downside and a minimum guaranteed return on the upside with unlimited participation, a combination of features that should appeal to investors expecting the market to trade range bound, advisers said.

In exchange, investors must give up dividends and invest over a five-year term.

Advisers had different opinions about whether such trade-off made sense to them.

If the final index level is greater than or equal to the initial level, the payout at maturity will be par of $10 plus the greater of the step return and the index return, according to an FWP filing with the Securities and Exchange Commission. The step return is expected to be 29% to 30% and will be set at pricing.

If the final index level is less than the initial level but greater than or equal to the downside threshold level, 80% of the initial level, the payout will be par plus the absolute value of the index return.

If the final level is less than the downside threshold level, investors will lose 1% for every 1% that the final level is less than the initial level.

Beats the index

Jerrod Dawson, director of investment research at Quest Capital Management, said the product was attractive when compared to a direct investment in the index fund.

“In the domain of negative returns, you’re better off if the index is anywhere between 0 and minus 20% because of the absolute return. You can actually do much better. Beyond a 20% drop, you’re no worse off,” he said.

“You’re either better or you’re equal to the index, not negative.”

He was referring to the performance of the price index since noteholders are not entitled to the 1.9% dividend yield paid by the index components.

“In the domain of positive returns, you will get at least 30% after five years. That’s 6% a year, or two-thirds of your dividends.

“And you’re not capped on the upside. So you’re not worse off [than] the index return.”

“You do have to give up the dividends. But it’s a good tradeoff for the downside.

“I’m usually not a big fan of those products. But this one seems quite attractive, particularly with the backdrop of high volatility. People can use some downside protection.”

Cost, step

Steven Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management, held a very different view.

“We have no problem with Royal Bank of Canada credit,” he said.

“But we don’t really like the note for a variety of reasons.”

He cited first the 3.5% fee disclosed in the prospectus.

“It’s 70 basis points. It’s a little bit on the high side,” he said.

Foldes’ second objection was the step return amount.

“A 29% to 30% is a pretty modest upside on a five-year. I understand there is no cap. But for starters, you’re giving up nearly 10% in dividends.”

Long tenor

Third, Foldes said he avoids longer-dated notes and five years was too long for his clients.

“You’re tying your money up for the benefit of this step return, which you may not need. If you think the S&P is going to trade range bound then it may make sense.

“But our view is that on a five-year term you should do better than that.”

Foldes’ relatively bullish view was supported by historical data and fundamental analysis.

Bullish view

“The step up is not such a high number compared to the historical performance of the S&P. I’d rather own the index fund and get the dividends as opposed to having the additional bells and whistles of this note.

“I know that a number of commentators are predicting lower returns over the next few years. But they’ve been saying that for a long time.

“Forecasts are forecasts,” he said.

On the fundamental side, Foldes said that the U.S. benchmark was not as expensive as most people think.

“We don’t see the market as hugely overvalued or undervalued on price-per-earnings basis. It’s not like the S&P is cheap. But it’s not expensive.

“Over five years we’re confident we could earn more than 6% a year,” he said.

Downside

Finally, the absolute return feature and barrier protection seemed useless to this adviser.

“You’re getting 6% a year, but you’re losing 2%. That’s one of the conditions to get the downside protection. But we think that you don’t need this downside protection. The absolute return is likely to be unnecessary as well,” he said.

“Over five years, point to point, the probabilities of having a loss are very slim. And if you did have a major loss, the barrier would not help you because a barrier is not a buffer. If it’s breached, your protection goes away.

“Both the barrier and the absolute return are a little illusory.”

For Foldes, the disadvantages of the structure surpassed the positive features.

“You’re locking your money up for five years. The digital return is very modest. You don’t get the dividends. In exchange for that you get a muted minimum return. I don’t see this note very attractive,” he said.

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

The notes (Cusip: 78014J413) will settle on Friday.

© 2015 Prospect News.
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