RBS' reset annual coupon securities linked to S&P 500 pose too much risk for 'small' coupon

By Emma Trincal

New York, June 9 - Royal Bank of Scotland NV's upcoming annual reset coupon securities due June 2014 linked to the S&P 500 index lack a favorable risk/return profile, sources said. The upside is capped to a nominal coupon while investors can lose almost their entire principal.

"You can't do more than 5% per year on the upside. But you can lose 80% of your principal. Do I need to say more?" said Steve Doucette, financial adviser at Proctor Financial.

The amount of coupon payment depends on the performance of the underlying index, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return on the relevant observation date - in June of each year - is zero or positive, the coupon will be 5.05% for that year. Otherwise, the coupon will be 2%.

For each interest period, the initial index level used to calculate the return will be the index's level on the previous observation date, not the level on the initial pricing date. As a result, the index needs to grow or stay the same consistently, year over year, in order for investors to get the maximum coupon, observed Doucette, a goal more difficult to attain than if the comparison was based on the level on the pricing date.

The payout at maturity will be par unless the final index level is less than 80% of the initial index level, in which case investors will lose 1% for every 1% decline below the buffer.

Small coupon, big risk

Doucette said that the notes do not fall into the definition of income products because the value of the coupon is performance based. And yet, the notes lack the main benefits of an equity product as investors are not able to participate to the upside, only to the downside, once the 20% strike is hit.

"I really don't like the risk/return profile on this one," Doucette said.

"I'd much rather be in a 10-year Treasury that yields 3%. I can sell my Treasuries anytime, and even if rates do go up, the market risk I'm taking with a government bond is much less than with the S&P 500."

Doucette said that he did not like the fact that investors could not get more than a 5.05% annual return even in a bull market.

"I'm not going to take 80% market risk for a small coupon. Why would you get into an equity-based derivative for a coupon?" he said.

Investors may get the minimal coupon of 2% if the market declines from one year to the next, and if it happens each year, the maximum return earned by the investor on the three-year term will be 6%, not 15%, he noted.

"If I want some coupon, I am going to look elsewhere. You can get a CD for that at 1.75% or 2% and it's FDIC insured," said Doucette.

He said that if he had to be exposed to equity risk, he would prefer to invest in an autocallable product linked to a broad index, which could offer the same degree of protection with a double-digit return as well as the possibility of an early redemption.

Too complex

Matt Medeiros, president and chief executive officer of the Institute for Wealth Management, said that the product is too complex for its limited benefits.

"I don't understand the complicated structure for a nominal return," he said.

"I just don't see why you would do that. It's a complicated way to get a small, limited coupon while having all the equity exposure.

"If the S&P 500 is up 30%, my upside is 15%. You're capped.

"When you're getting a nominal spread over the 10-year Treasury and when you're not getting the benefit of the equity upside, it doesn't seem to make a lot of sense to me."

The notes (Cusip: 78009PAT8) are expected to price June 27 and settle June 30.

RBS Securities Inc. is the agent.

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