RBC’s $3.55 million barrier digital plus on Dow, Russell, Nasdaq likely to outperform

By Emma Trincal

New York, July 1 – Royal Bank of Canada’s $3.55 million of 0% barrier digital plus notes due July 2, 2026 linked to the lesser performing of the Dow Jones industrial average, the Russell 2000 index and the Nasdaq-100 index offer long-term investors a wide range of opportunities to outperform the market either on the upside or on the downside, advisers said.

If each index finishes at or above the initial level, the payout at maturity will be par plus the greater of the least performing index’s gain and the fixed return of 60%, according to a 424B2 filing with the Securities and Exchange Commission.

If the worst performer falls but finishes at or above the 80% barrier level, the payout will be par. Otherwise, investors will lose 1% for each 1% decline of the worst performing index from its initial level.

Entry point

“I think this is an interesting structure,” said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

“I like the fact that it’s a little bit of a longer term. I also like that there is no cap if the worst-of does better than expected.”

Medeiros was also comfortable with the downside protection.

“The barrier seems adequate relative to the market pullback that we’re in. The Nasdaq is down almost 30% so far this year and the Russell, close to 25%.

The longer maturity requires paying attention to the issuer’s creditworthiness.

“I don’t have a particular opinion on Royal Bank of Canada. But credit risk is something you need to take into account, for sure. This is a four-year note, not a 12- or 18-month note,” he said.

Medeiros said the 60% digital payout was a “decent return,” especially since investors may still fully participate in the upside.

Usually, I’m not a big fan of worst-of. But given the lower entry points and the four-year maturity, it’s worth taking the risk,” he said.

Credit, fee

A financial adviser also liked the notes.

“I’m comfortable with Royal Bank of Canada. It has good credit ratings and Canadian banks in general are strong,” he said.

Royal Bank of Canada has an AA minus rating from S&P Global Ratings.

“I also like the cost. 0.75% for a four-year note is extremely competitive,” he said commenting on the fee amount disclosed in the prospectus.

Digital plus

The payment of a minimum return as long as the worst performing index is not negative was one of the most attractive aspects of the product, he said.

“You’re going to get about 11% compounded per annum, which is nothing to sneeze at. The normal long-term rate of return of equity is 10%, so it gives you a decent amount above historical average,” he said.

Such result satisfied one of his buying criteria.

“I always want to get an equity-type of return if I’m going to take equity risk,” he said.

The “plus” aspect of the upside payout was another benefit to investors.

“Your gain is uncapped, which is good if you have a lot of confidence that the market could take off,” he said.

Back testing

Before purchasing structured notes, this adviser examines the probabilities of return outcomes using historical data.

“I have the numbers for the Dow but not for the Nasdaq. For simplicity’s sake, I’ll use the data I have on the Russell. It’s a pretty volatile index, so it should give me an idea although I don’t have the tools to model the worst-of risk,” he said.

Digital performance

The notes are the most likely to outperform if the index finishes up and below the 60% fixed return. Over four-year rolling periods, this outcome has occurred with a frequency of 59.2%, he said.

“That’s really good. Almost 60% of the time, I’m going to outperform on the upside,” he said.

In the other upside scenario, investors would be “capped out” if the index rose above 60%. Such outcome has occurred 28.1% of the time, he noted.

“In this scenario and since there is no cap, you’re not going to outperform. You’re just performing the index minus the dividends.”

The underlying index with the highest dividend payment is the Dow paying 2.17% in dividend yield. But giving up dividends is “part of the territory” when investing in structured notes, he said.

Correlations

“I don’t know in advance what my exposure will be. It’s just going to be the worst-of. Because of that, my analysis has its limitations. That’s why it’s important to look at the correlations between the three,” he said.

The lowest correlation is between the Russell 2000 and the Nasdaq-100 with a coefficient of 0.82. A coefficient of correlation of 1 indicates a perfect correlation.

“They’re not as correlated as the usual Dow and S&P. But at the same time, it’s not like one is going to be up 100% and the two others down 10% and 30%. So, it’s reasonable,” he said.

The Dow and the S&P 500 index show a 0.96 coefficient of correlation.

Downside scenario

On the downside, this adviser examined the frequencies of two separate scenarios: a decline above and below the 80% barrier threshold.

Over four-year rolling periods, the Russell has declined at or above the barrier threshold 10.8% of the time, he noted. The loss scenario (barrier breach) occurred only 1.9% of the time.

“You only have about a 2% chance to lose money with this 80% barrier. That’s a risk I can swallow. It’s a small risk because this is a four-year period. We’re already down a lot and you have plenty of time to recover,” he said.

Two out of three

Investors will outperform when the worst-of index closes within a -20% and +60% range, he noted.

“70% of the time, you’ll beat the index. 98% of the time, you’ll either beat the index or match the index. There’s only a 2% chance of losing money if you look at the historical data,” he said.

The 60% minimum return “isolates” investors from the odds of a mediocre performance.

“The worst index could be trailing the others. But you’ll get a boost,” he said.

“This is one of the rare structured notes that meets my criteria, which is to win two out of three times.

“It’s a pretty nice offering.”

RBC Capital Markets, LLC is the agent.

The notes settled on Friday.

The Cusip number is 78016FMX9.

© 2015 Prospect News.
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