RBC’s contingent coupon buffer notes on S&P 500 to mix booster, leverage in innovative trade

By Emma Trincal

New York, Oct. 5 – Royal Bank of Canada’s contingent coupon buffer enhanced return notes due Oct. 19, 2021 linked to the S&P 500 index show several innovative features that make the product a mixed play between income and equity as it combines leveraged participation and a digital payout, sources said, commenting on the filing.

A knock-in event will occur if the index closes below the knock-in level, 85% of the initial level, on any day during the life of the notes, according to an FWP filing with the Securities and Exchange Commission. This barrier type is called “American,” as opposed to a “European” barrier observed at maturity.

Each quarter, the notes will pay a contingent coupon at a rate that is expected to be 4.25% to 5.25% per year unless a knock-in event occurs, in which case no coupon will be paid for that quarter or any subsequent quarter.

If a knock-in event does not occur, the payout at maturity will be par plus the final coupon.

If a knock-in event does occur, the payout at maturity will be par plus 117.65% of the sum of the index return and 15%. As a result of this calculation, the payout will be more than par if the final index level is greater than the knock-in level and less than par if the final index level is less than the knock-in level.

Dangerous knock-in

“It’s a variation around the autocall contingent coupon theme except there is no call. What you want is never get the knock-in,” a structurer said.

The knock-in event indeed is a negative event for investors who would buy the notes for income.

“Once the knock-in happens, no more coupon, and since it can happen any day, you knock in on day two, you have zero coupon for five years. Not so attractive,” he said.

A traditional autocallable contingent coupon would “make it easier” for investors to collect the interest rate, he said.

That’s because the observation for the coupon payment is based on the price level on only the observation date, not on any day, he said. In addition, investors who miss a coupon with an autocallable contingent coupon can “make it up” later as coupons in general accumulate.

Finally the autocall by itself mitigates risk as investors have reasonable chances of getting their money back prior to maturity, he added.

Booster and leverage

That said, investors have a reason to consider the notes, and the issuer probably “priced it correctly,” he said.

The incentive on the investors’ side is probably what happens at maturity if a knock-in event has occurred.

“You’ve been penalized on the coupon payment, depending on how soon the knock-in happened, but they give you a chance to make it up with a forward leverage,” he said.

The payout formula at maturity offers a leverage factor of 1.1765 on the upside and the downside. But the formula adds the 15% buffer amount to the return percentage, with the leverage being applied to the sum of the two, creating a greater return potential than a similarly levered note without the additional payment.

Not your grandma’s buffer

Because the return is not capped, there are three possible return outcomes, he said.

If the index drops below the 85% threshold, investors may lose 100% of their principal, which is how the leverage factor is calculated. “This is not new,” he said, explaining that such outcome triggers the normal accelerated losses that occur once the underlying price drops below a geared buffer level.

What is different is the second scenario, in which the index is negative but closes above the buffer threshold. The leverage applies in that range as well, which gives investors a potential gain of up to 17.65% instead of getting only their principal back at maturity.

Perhaps the most novel aspect of the payout at maturity is when the index finishes positive, he said. Investors then receive the leveraged buffer amount of 17.65% plus the leveraged return of the index price.

For instance, a 25% appreciation in the index at maturity would provide a 47% gain by adding the leveraged return to the leveraged buffer amount, which is the sum of 29.41% and 17.65%.

“They apply the gearing on the downside and on the upside. On top of this they’re paying you the equivalent of a digital coupon. It’s a leveraged forward plus a digital. They add a coupon to your leveraged trade,” said the structurer.

“That’s the deal. But it only happens if there’s a knock-in event. That means you only get this when the market has already dropped 15%.”

In options terms, the investor is long a forward when long a call and short a put at the same strike. In this deal, the forward is levered at a rate of 1.17 and struck at the money, which means its strike price is the initial price of the underlying.

“Leverage plus bonus: it looks good,” he said.

“But for you to get it, the market has to be down 15% at some point. When that happens, you stop receiving your coupon. It’s no longer an income note. Instead they change the structure and give you an equity deal. No more coupon, but you have a leveraged forward on the S&P at maturity.”

The American way

This structurer said that the notes are less attractive than an autocallable contingent coupon note if the goal is to receive income. However, not having to use a worst-of is a benefit.

“It’s one reference asset only. If you don’t want a ridiculously small coupon, you have to use an American barrier. They had to price it that way,” he said.

But this structurer was unsure whether the equity payout at the end is worth the risk of not getting the coupon.

“You can’t get called early. It’s not easy to get the coupon. It’s actually pretty easy not to get it. So yes you get that equity play at the end. It’s an interesting play. But it’s got to be pretty hard to sell to an investor,” he said.

He speculated that the buyer would be an individual investor, not an institution, although he admitted not knowing. “I can’t imagine an institutional investor doing this. The chances of not getting the coupon are just too high. The idea of easily losing your coupon and trying to make it up at maturity by changing a contingent coupon into a contingent leverage equity deal is a bit of a stretch,” he said.

Reverse inquiry maybe

A sellsider also wondered who would consider the notes, although he held an opposite view on who may buy them.

“You’ll never sell this to retail because no one knows if it’s an income or a growth deal. What would be the person’s motivation for buying that? Honestly I have no idea. But it’s definitely interesting,” this sellsider said.

“It’s got to be a reverse inquiry ... some high net worth or family office possibly if I had to guess.

“Maybe they had a lead order and they’re showing the notes to see if there is some piggy-backing.”

Weak on income

This source agreed with the structurer on what is likely to be the weakest spot of the structure: the uncertainty of being paid a coupon.

“The coupon can get knocked out permanently. That means you no longer get income. Why would you do that if you’re interested in income?

“Putting together income and growth is kind of odd.

“I’m not saying it’s a bad deal. It’s actually pretty interesting. But I can’t understand the viewpoint of the investor. This is why I’m guessing that it’s probably a one-off.”

Strong on growth

By contrast, the equity growth part of the structure at maturity is the most compelling, he said.

“It’s a complex strategy, but the real value is this equity kicker. For sure, it’s no longer an income note, but the buffer and the leverage at the end are interesting,” he said.

“If it was me, I would take out the coupon portion of the deal and move the geared buffer down from 15% to 20%.

“I’d get more downside protection, better upside potential and forget about these coupons that eventually get knocked out. I’d make it a growth note.

“The booster and leverage at the end give you a reasonable growth structure. I would just keep it that way.”

Inventive shop

Stressing the uniqueness of the product, this sellsider said that he may have an idea of who structured it.

“I’ve never seen something like that. I wouldn’t be surprised if it was a Morgan Stanley deal. They tend to do very creative stuff like that,” he said.

“They come up with a new wrinkle, combining leverage and a booster. If the traders can quantify it, they can do it.”

Coincidentally Morgan Stanley Finance LLC just announced a similar payout in a 15-year worst-of deal to price at the end of the month. The deal (Cusip: 78012KUD7) is different – it is autocallable, it references two indexes, the Euro Stoxx 50 index and the Russell 2000 index, and has no American barrier – yet, the final payout is similar, according to an FWP filing with the SEC.

If the final level of each index is greater than its respective threshold level, 66.6667% of its initial level, investors will receive a positive return of 1.5% for each 1% by which the final level of the lesser-performing index is greater than its threshold level. However, if the final level of either index is less than its respective threshold level, investors will lose 1.5% for each 1% by which the final level of the lesser-performing index is less than its threshold level.

RBC Capital Markets LLC is the underwriter for the RBC notes, which will price Oct. 14.

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