RBC’s $1.35 million absolute leveraged notes on Stoxx offer alternative to index fund

By Emma Trincal

New York, July 31 – Royal Bank of Canada’s $1.35 million of barrier absolute enhanced return notes due July 26, 2028 linked to the Euro Stoxx 50 index provide downside protection, absolute return and leverage, making the product a good alternative to a direct investment in the index fund, advisers said.

If the index finishes at or above its initial level, the payout at maturity will be par plus 173.5% of the index return, according to a 424B2 filing with the Securities and Exchange Commission.

If the index declines up to the barrier level, 60% of the initial index level, the payout will be par plus the absolute value of the index return.

Otherwise, investors will lose 1% for every 1% decline of the index from its initial level.

Return potential

“That’s pretty good. Everybody is stretching for returns lately. I’ve been around for some time and this one is not a bad deal at all. Much better than an 8% autocall,” said Ken Nuttall, chief investment officer at BlackDiamond Wealth Management.

Issuers are having a hard time offering attractive terms due to low volatility levels, he said.

“It doesn’t make it any easier when you have alternatives like T bills.”

But the structure could still be improved.

More leverage

For one thing, Nuttall would want more upside leverage.

“1.73 times is nice but probably not enough,” he said.

A better balance could be achieved between the upside and the downside.

“Personally, I think you’re spending too much on a 40% barrier on a five-year.

“Is the European stock market going to drop 40% in the next five years? I don’t think it will,” he said.

As with any structured notes, investors get exposure to the price return of the index, which excludes dividend payments.

The Euro Stoxx 50 index pays a high dividend yield of 3.12% compared to the S&P’s 1.54%.

“Notes on the Euro Stoxx are often attractive because it has that nice, juicy yield. You’re not being paid the dividend directly but you’re more than compensated for it. The 1.73 leverage certainly makes up for it plus you have a lot of downside protection as well as the dual directional feature.”

Solid benchmark

Investing in international markets, especially in Europe, makes sense, he noted.

“Europe has been lagging. Everything but the U.S. has been lagging. There is a lot of potential in non-U.S. equities,” he said.

“The Euro Stoxx is basically the Dow of Europe. These are high-quality companies. I don’t think you’re going to go wrong with those names.”

The top holdings of the index are semiconductor firm ASML Holding NV, luxury goods company Moet Hennessy Louis Vuitton SE, Total Energies SE and SAP SE.

Fine-tuning the barrier

In order to raise the leverage,” Nuttall said he could cut the contingent protection from 40% to for instance, 20%.

“If you keep the same five-year duration, I think you can be fine with a 20% barrier,” he said.

RBC has been showing similar deals, which piqued his interest as well, he said.

“We’re doing one that’s trading [Monday]. It’s a two-year on the S&P, 2x up with a 19.1% cap, 30% barrier and dual directional,” he said.

“It makes sense to have more barrier protection on the short side of a trade. Over five years, the chances of being down 30% are minuscule, let alone 40%.

“We think 30% on a two-year is fine. So, if would feel relatively comfortable with a 20% barrier on a five-year if I can get more upside.”

Core holding

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

“It’s an attractive note. First, Europe is going to be in my portfolio regardless. It’s important because if I’m going to be holding something for five years, it has to have a place in my asset allocation,” he said.

The note would be included in the international equities bucket.

“When you’re talking about international equity, you’re basically talking about Europe,” he said.

For instance, the main benchmark for non-U.S. developed markets, the MSCI EAFE index, has more than 60% in Europe, he noted.

“With the Euro Stoxx 50, you’re basically buying the S&P in Europe. It’s essentially the benchmark for non-U.S. stocks, excluding emerging markets,” he said.

Alternative to equity

As always, when a note can fit in a portion of his equity portfolio, the main question Kunhardt asks himself is whether he would be better off holding the asset long or via a structured note.

“The fact that you have the leverage with no cap on the upside and a protection of 40% on the downside, that pushes the decision in favor of the structured note,” he said.

Giving up the dividend yield was not a concern.

“Am I really giving it up? I’m not. I have the leverage on the upside.

“To sweeten things, not only do you get your principal back if you don’t breach the barrier, but you can turn the downside into a positive return. That’s the beauty of absolute return,” he said.

Geopolitical risk

Both downside features – the protection and absolute return – were valuable when investing in a region that has become riskier than in the past since Russia’s invasion of Ukraine early last year.

“There were reports this weekend that Russian mercenaries were moving closer to the Polish border. Europeans can’t get along with each other. It’s been like that for hundreds of years. This whole situation to me is reminiscent of the beginning of World War I.

“There’s never too much downside protection when it comes to this part of the world. Geopolitical risks are rising in Europe.”

But Kunhardt said he was still comfortable with the risk-reward given the duration of the note and the conservative barrier size.

“It’s a good note. If you invest in Europe as any asset allocator does, that’s the type of note you should look into. It’s a better alternative to a long position.”

RBC Capital Markets LLC is the underwriter.

The notes settled on Friday.

The Cusip number is 78016NKT3.

The fee is 0%.

© 2015 Prospect News.
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