RBC’s absolute return notes linked to S&P 500 target only bears with 50% upside participation

By Emma Trincal

New York, July 24 – Royal Bank of Canada’s absolute return notes due Jan. 29, 2021 linked to the S&P 500 index cut the upside participation by half in order to provide return enhancement on the downside. While advisers agree the technique is unusual, they said its benefits, mainly designed for bears, will be limited.

If the index finishes above the initial level, the payout at maturity will be par plus 50% of the gain, according to an FWP filing with the Securities and Exchange Commission.

If the index falls by less than the buffer level of 19.5% to 22.5%, the payout will be par plus the absolute value of the index return. The exact buffer will be set at pricing. Sources assumed a 20% hypothetical buffer.

Otherwise, investors will lose 1% for each 1% decline beyond the buffer.

Unusual participation rate

“I’ve never seen something like this, and I’ve been looking at notes for a while,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

He was not referring to the absolute return feature but to the fact that the upside participation is not the standard one-to-one or more.

“I’m not sure which way I feel,” he added.

“When you start playing with participation, it reminds me of equity-linked annuities. I’m not crazy about that.

“What intrigues me is the downside. It’s a very generous downside with the absolute return and the buffer.”

Most absolute return products, he noted, are constructed with a barrier.

“It’s not a note I love, but it’s certainly one that gets my attention and that I would consider.”

Correction likely

Kunhardt’s market view is in line with the market consensus. He expects a sell-off given the toppish market.

“There is no way this trend will continue, and of course a correction is imminent, but no one knows when.”

Kunhardt, however, does not believe the market is headed to “another 2008” crash.

“2008 was a 100-year event. I don’t see a repeat of this. But are we looking at a correction? We definitely do.”

For that reason, the notes would be a “no-brainer” if used for its downside features. The structure could either generate alpha if the market is down by less than 20% or cut the losses if it declines more than 20%. A buffer, unlike a barrier, would allow investors to outperform the benchmark.

Upside is out

The upside, of course, is not quite as good.

Kunhardt said that from listening to the forecasts of most major research firms, whenever predictions remain bullish, the expectations are modest for the coming years.

For the next five years, forecasts for the annual return on the S&P 500 are around 5½%, he said.

“Here I only get half of this. I get 2¾%. They give you a bond return, and a bond would be safer.

“There is no reason to do it unless you are bearish and only playing it for the absolute return. That’s the only way I would do it. Otherwise, why would I take equity risk to only get a bond return?”

For mild bears only

Investors in the notes would have to be bearish but not overly bearish since the absolute return feature no longer works after a 20% market decline.

“While you’ll beat the market beyond a 20% decline, nobody wants to take a loss,” he said.

If the market consensus turns out to be true, investors in a mildly bullish market would be penalized. They would only get half of an already modest market performance.

“I think this is the biggest issue. It’s a bearish play on equity and nothing else. There is no upside, no meaningful upside at all.”

Costly buffer

Steven Foldes, vice-chairman at Evensky & Katz/Foldes Financial Wealth Management, did not even think the notes are suitable for bears. The scenario in which investors may comfortably outperform the market is unlikely to unfold in his view, including on the downside. On the upside, bulls are guaranteed to underperform the index.

“This 50% participation is unusual,” he said.

“You do have a buffer, and you do have this absolute return, but the S&P has to be down modestly to take advantage of it.”

The buffer is expensive, costing investors too much, he added.

“Over a three-and-a-half-year period, it would be unusual for the market to be negative,” he said.

“You’re paying a lot for both the buffer and the absolute return. And that’s because you’re giving up a lot for it, and you may not even need it.”

Dividends

The first and main “cost” to investors is to leave on the table half of the index appreciation.

If the market were to return 10% a year, which has been its historical trend, he said, investors would only get 5%.

A slower market performance would feel even worse for noteholders.

Second, investors must forego dividends for three and a half years. On an index yielding 2%, the opportunity cost represents about 9% of the compounded value of the dividend stream over the period, he noted.

“What you’re really getting is the absolute return and that’s it,” he said.

“The bet is almost asymmetrical. You’re not receiving the dividends, you’re getting half of the appreciation ... and your chances to benefit from those terms are very slim and limited to only a small portion of the downside.”

Very specific bet

For Foldes, the range of outperformance is “narrow,” for several reasons. First, the index would have to be negative, not positive. Second, the losses should not exceed the 20% limit. Finally, small losses would represent a poor risk-adjusted return. The bet offers real value only if the index finishes on the lower end of the absolute return range, somewhere between negative 15% and negative 20%, he explained.

“This window is so narrow. You’re going to get nothing except the downside protection. You’re unlikely to get a decent absolute return,” he said.

A more likely outcome in a bearish scenario during that length of time would be a small gain induced by a small drop in the index level.

“If the index is down 5%, I’ll make 5%. I’d much rather be on the side of making money if it was positive and if I had some leverage,” he said.

Not for all bears

Even bearish investors may not benefit much from the structure.

“If I’m bearish, I have to have the same narrow window to bet on. If it’s down more than 20%, I lose money. I have to be bearish but more importantly modestly bearish.”

A true bear would want full participation to the downside.

“If I held that view, I would want to benefit from any loss, including a big loss,” he said.

The notes have other characteristics, some of which are equally negative.

On the positive side, the credit risk of the issuer is reasonable, he said.

On the negative side, the 2.75% fee is “too high” and the duration is too long for this adviser.

Confusing

Another drawback is the complexity of the notes.

“The idea is somewhat complicated as it relates to the client,” he said.

“I will make money if the market is down to a certain point, but I will lose money if it’s down more.

“It’s the kind of thing that can be easily misinterpreted.

“The 50% participation would be a further complication. It would be challenging explaining that to a client as well.”

Overall, Foldes concluded that investors are more likely to underperform the index or lose money than to generate a decent absolute return from the product.

“Your maximum benefit is limited to a very narrow range, one in which you’re unlikely to fall into,” he concluded.

RBC Capital Markets, LLC is the agent.

The notes will price on Wednesday and settle on Monday.

The Cusip number is 78012K3J4.

© 2015 Prospect News.
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