RBC's buffered bullish knock-out notes linked to S&P 500 seen as putting brakes on bulls

By Emma Trincal

New York, April 12 - Royal Bank of Canada's 0% buffered bullish knock-out notes due April 30, 2014 linked to the S&P 500 index penalize the very bullish investor, but the benefit of the structure is the downside protection it offers on a relatively short duration, sources said.

If the index return is positive but not by more than the knock-out percentage, which will be 21% to 25%, the payout at maturity will be par plus the index return. If the return exceeds the to-be-set knock-out percentage, the investor will receive par plus the 10% knock-out return, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by 15% or less and will lose 1% for every 1% that it declines beyond 15%.

The prospectus clarifies a couple of upside scenarios with examples that assume a knock-out percentage of 23%.

In one example, the index finishes up 15%. Investors in this case get the same value - a 15% positive return - as if they were just long the index because the index performance has not exceeded the 23% knock-out.

In another example, the index ends higher by 30%. Investors in this context only pocket 10%, the knock-out return. They underperform the benchmark by 20%.

Sideways view

Steve Doucette, financial adviser at Proctor Financial, noted that the payout structure is worse than having a 23% cap. With the RBC notes, investors get less than 23% if that knock-out level is reached, whereas a 23% cap would give them 23% and not less than that.

But the structure can be justified by the need of an investor to express a bullish view combined with the desire to get attractive protection on the downside.

"If you believe the market will be trading range bound - and everybody seems to believe this - we can even structure notes like this. I guess if you think the market won't go up that much, you get a nice buffer," he said.

On the upside, investors have the opportunity to make up to 23%, he noted. If the market does outperform a lot, their return will only be 10%, or 5% a year.

Price for protection

"It's a huge penalty you pay in underperformance. If the market ends up 24% higher, you lose 14% of it immediately," he said.

"At least you get a decent buffer. And you have your 5% per year, and so be it."

Doucette said that the notes fit a certain market view for any bullish investor who does not see the market rallying all that much.

"But it's hard to say which way the market will go in two years," he said.

"We're already two years out a bull market. The average bull and bear market lasts four and a half years.

"The risk is if the market goes all the way up. That's you're opportunity cost: 10% instead of 23% and all the way up."

The option that triggers the lower return once the knock-out event occurs would play against investors seeking to exit their investment early, he said.

"As you approach maturity, if you get above 23%, you would be subject to a strong penalty if you wanted to sell on the secondary market because the option is negative. It's a viciously negative component of this note," he said.

Shark notes

The product uses the shark note model, a structure that gives investors upside participation up to a point. Typically, once this threshold is crossed, the participation to the upside disappears altogether and the investor gets nothing, according to a structurer.

In this case, a fixed payment is offered to reduce the severity of the penalty. Doucette said that this payment could be increased to accommodate some bullishness.

"It's very odd. You could have a little creativity here. For instance, you could lower the knock-out percentage on the upside and increase the flat return by more than 10%. I mean ... put together something that's not so harsh," he said.

Many of the shark notes, however, are built around full principal protection rather than a mere buffer, according to the structurer. They may or may not offer a fixed payment if the knock-out level is exceeded by the underlying asset.

Make it short

For a market participant, the drive behind the demand for these products is duration.

"It's a way of giving a downside protection on a short-term note," the market participant said.

"I personally love the pure, easy-to-understand plays. This one is not that easy to explain."

He mentioned a deal he recently noticed: Morgan Stanley's upcoming 0% market-linked notes due April 28, 2017 linked to the Dow Jones industrial average.

The five-year product gives investors 100% participation on the upside as well as a full capital guarantee if the benchmark finishes negative subject to the issuer's credit risk.

"I really think the crown jewels are products like this [Morgan Stanley note]. But you can't get the full principal protection for a two-year. The pure play pushes you out further than that," this market participant said.

"Any product has to meet the specific needs of an investor. Its value depends on how it works for the client.

"There are enough good advisers to ask their clients why they should limit their investment horizon to two years.

"Once you see that they really want a short-term investment, you may ask what they think the market will be in two years. If they say not much up, maybe up 15% and not drastically down, maybe down 10%, then this type of note does make sense.

"Often time, such deals are created at the request of the client. It could be for a sophisticated investor who understands the concept. The client likes it. And maybe it's the right deal.

"The deciding factor is definitely when someone wants to push for the two-year term. You can't build a good protection on a two-year without some sort of a twist. This one, though, requires some explanation."

The notes (Cusip: 78008T4N1) are expected to price April 25 and settle April 30.

RBC Capital Markets, LLC is the agent.

© 2015 Prospect News.
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