RBC’s leveraged notes on index basket disappoint due to small buffer, low cap, advisers say

New York, July 26 – Royal Bank of Canada’s buffered enhanced return notes due Sept. 1, 2022 linked to a basket of equity indexes did not match the expectations of two financial advisers expecting a higher maximum return and more generous buffer on the notes.

The basket consists of S&P 500 index with a 60% weight and the Russell 2000 index with a 40% weight.

If the basket return is positive, the payout at maturity will be par plus 1.5 times the basket gain, capped at $1,095 per $1,000 of notes, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the basket falls by up to 5% and will lose 1% for each 1% decline beyond the 5% buffer.

After thought

Carl Kunhardt, wealth adviser at Quest Capital Management, said the terms were disappointing.

“Why even make a buffer? Obviously, 5% is just an after-thought,” he said.

“Plus, the cap. You just get 1% above what you expect the S&P to produce anyway, and that’s if your outlook is conservative.

“If things go well, the Russell is there to juice the return. But you’ve capped it. You’re taking the risk of the Russell but you’re not getting the return.”

In a hypothetical example, he assumed the S&P 500 index would gain 10% and the Russell 2000, 15%, over the period.

“It’s a basket. Great. But I’m getting 9.5%,” he said.

A direct equity investment in the basket with the same 60/40 allocation would return 12%.

“I’m taking the risks of those indices without the returns,” he said.

Russell risk

Kunhardt saw the main risk in the small-cap benchmark.

“The Russell 2000 is very sensitive to any economic slowdown. We saw the impact of the lockdowns on small businesses last year,” he said.

His concern was how local governments may respond to the Delta Covid variant.

While the Federal government and most states lifted mandatory mask requirements, some counties, including those of big cities have reinstated the mandates, he said.

“Mask mandates are back. It’s not decided by the states anymore, but it’s county by county,” he said.

He cited the counties St. Louis, Missouri, Los Angeles, Clark County, which includes Las Vegas and even Dallas County.

Restaurants, debt ceiling

“People have to wear masks at work or when shopping or going to restaurants. Businesses must require their customers and employees to cover their face. If it goes on like this, small businesses, especially restaurants are going to get crushed again.

“If they start requiring again 50% occupancy in restaurants, people are going to lose their jobs again and small businesses will just go under.”

The risk of future lockdowns and restrictions was not just a threat for restaurants, he said but for most small businesses struggling with labor and supplies shortages.

Another risk, this time for all U.S. stocks and even bonds is looming next week with the Congress debate over the debt ceiling. The suspended borrowing limit expires on July 31.

“These risks are real. Still, I remain bullish on the market,” he said.

“Right now, under current market conditions both indices are on track to surpass the cap,” he said.

“They can exceed the cap without the leverage. So why would you use this note for such a small protection while you could do 12% to 14%?”

Too rich

Steven Foldes, vice-chairman at Evensky & Katz/Foldes Financial Wealth Management, held a similar view about the notes.

“My experience with RBC has been good although I don’t know what their CDS spreads are,” he said.

“We do like the short tenor. But that’s the only positive thing I can see with this note.”

The notes carry a 1.1% fee, according to the prospectus.

“A 1.1% fee on a 13-month note is very high,” he said.

“And the 9.5% cap on a 13-month is very low for a basket, which is not providing much diversification given the high correlation between its two components.”

Disappointments

Usually, Foldes said he likes leveraged buffered notes. But this one did not meet his expectations.

“You see 1.5x leverage and start to get excited. But then the cap is so low. It takes away the excitement. This cap is below the historical rate of return of either the S&P or the Russell,” he said.

The 9.5% maximum return over 13-month can be achieved if the basket gains 8.75% on a compounded annualized basis.

“You’re also giving up at least 1% in dividend,” he added.

The S&P 500 index yields 1.34% and the Russell 2000, 0.83%.

“Then you get excited because there’s a buffer. But the buffer is so low as to be insignificant.

“If I’m going to own a 60/40 basket, I don’t want to be capped out below the historical average rate of return and I certainly don’t need a 5% buffer.”

Narrow window

Only a “minority” of investors would be interested in the notes, he added.

“If you’re bearish you don’t get the protection,” he said.

“If you’re bullish, you get less than the historical average.

“You would need such a moderately positive view over the next 13-months. It’s a narrow window.

“I’d rather own the two indices, get the dividends and not have to pay 1.1% in fee.

“There is really no reason to own it.”

RBC Capital Markets, LLC is the agent.

The notes will price on Tuesday and settle on Friday.

The Cusip number is 78016EQV2.

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