RBC's rainbow notes linked to basket of indexes bring optimal allocation, correlation risk

By Emma Trincal

New York, July 27 - A planned note linked to three equity indexes allows investors to get more exposure to the best-performing index and a minimal exposure to the index that generates the lowest return.

Some find the structure too risky due to the correlation between the three basket components and the lack of protection. But for others, the dynamic allocation is a way to enhance the return/risk profile for the investor.

Royal Bank of Canada plans to price 0% allocation optimizer notes due Aug. 15, 2014 linked to a basket of indexes, according to an FWP with the Securities and Exchange Commission.

The basket is comprised of the S&P 500 index, the S&P Midcap 400 index and the Russell 2000 index.

On the Aug. 12, 2014 valuation date, the best-performing index will be given a basket weight of 60%, the second best-performing index will be given a weight of 30% and the worst-performing index will be given a weight of 10%.

The payout at maturity will be par plus the basket return, which can be positive or negative.

Up and coming

An industry source talking about those structures, often called "rainbow" notes, said that he is optimistic about their development.

"Those dynamic optimizing strategies are coming up more and more. We're at the very beginning of a trend," he said.

"It's a passive yet dynamic strategy, a smarter way to allocate money moving forward.

"Investors like it because it has the potential to reduce risk while enhancing returns."

The term "rainbow" derives from the underlying options used to structure those deals. A rainbow option is a derivative exposed to two or more assets. Investors via puts and calls get exposure to either the best or the worse of some of the underlying assets.

Risks

The prospectus stated three types of risks, which a distributor said he is paying attention to.

First, the notes do not offer any principal protection, according to the prospectus.

Second, the growth of one index could be offset by the decline of the others.

Finally, because each index tracks a sub-set of the U.S. equity market, they are highly correlated. As a result, the decline of one of them could easily coincide with the decline of the two others.

Not this one

"I've seen those before, and I like those rainbows structures in certain circumstances. But I wouldn't be interested in this one," the distributor said.

"I need principal protection with this type of product, which you don't have here."

He said that more often than not a downside protection is usually offered with those products, which tend to have long-dated maturities.

"I also don't like the high correlation between the three indexes," he said.

"More correlation means that eventually the three benchmarks could go down at the same time, which puts your capital at risk," he said.

However, the distributor said that he would like this structure used with a different market perspective.

"I do see some value in this type of product as a hedge against a long-only equity position," he said.

"But since you don't short a structured note and since those products are long only, I would have to do a customized deal, tailoring this type of note with a bearish point of view."

Pricing necessity

For the industry source, though, correlation between the basket components is part of the way rainbow structures usually work.

"Those products are not meant to give you exposure to non-correlated assets," he said.

"For better pricing, it's important for the issuer to have at least two correlated indexes in the underlying basket, otherwise you can't get the structure to work as the options cost too much."

He said that when a structurer puts together a plain vanilla structure, pricing is not such a constraint. But the embedded rainbow options introduce an element of uncertainty that requires some conditions, including some level of correlation between the basket components.

"With a static basket, you can offer more uncorrelated assets. But if you're going to create a dynamic optimization at the end, it's got to work from a pricing perspective," he said.

Finally, this industry source said that even if the three indexes move together, they may go up, with one going up more than the others.

"You get a dynamic return with maximum exposure to the best-performing index," he said.

Risk monitoring

This industry source also noted that while the structure offers no downside protection, the dynamic diversification obtained at maturity does change the risk/return profile of the portfolio.

"This structure creates a dynamic and optimal diversification as opposed to a static allocation with a hard protection," he said.

"You may not have a buffer or a protection mechanism, but you have the ability to optimize your return after the facts, which you usually don't get from an investment.

"You may make the wrong bet on an asset for instance and yet, your exposure to it will be reduced to the minimum while your exposure to the best-performing asset will be enhanced.

"That in itself reduces your risk/return profile."

The notes (Cusip: 78008TLR3) are expected to price on Aug. 12 and settle Aug. 17.

RBC Capital Markets, LLC will be the underwriter.

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