RBC’s three-year enhanced return notes linked to S&P 500 have no cap, will appeal to bulls

By Emma Trincal

New York, Aug. 19 – Royal Bank of Canada plans to price 0% bullish enhanced return notes due August 2017 linked to the S&P 500 index, an offering that Dean Zayed, chief executive of Brookstone Capital Management, described as “extremely attractive” for strongly bullish investors.

The payout at maturity will be par plus 145% to 155% of any index gain. Investors will be exposed to any losses, according to an FWP filing with the Securities and Exchange Commission.

“We can debate whether a three-year note on the S&P at these levels fits or not our market sentiment, that’s one thing. But looking at the terms of the notes specifically, this product is very well suited for somebody who has an extremely bullish view on the market. It may not be for everyone. But the beauty of structured notes is that you can define the risk/reward up front based on your own view,” Zayed said.

The “bullish” elements of the structure include the lack of barrier or buffer and an emphasis on the return enhancement on the upside, he said.

“For a raging bull who is not concerned about the lack of downside protection, this is an extremely attractive note with a good issuer,” he said.

“The simplicity of the terms, the leverage ... for bulls out there, it’s beautiful.

“If I’m expecting that three years from now, we will have a correction or the market will trade sideways, although I would still appreciate the simplicity, the power of the structure, I wouldn’t buy it. For any purchase of a structured note, the market sentiment needs to coincide with the structure in place.

“For me and my clients, it would not be a good fit because we look at risk control. The lack of some sort of risk management embedded in the structure, and by that I mean the absence of any barrier or buffer, would be a drawback.

“But for strongly bullish investors, this is it.”

Magic of no cap

Steven Foldes, vice chairman of Evensky & Katz/Foldes Financial Wealth Management, said that he likes the structure.

“A note like this is very interesting. It’s an excellent note,” he said.

“The first thing you look at is the creditworthiness of the underlying issuer, and RBC has strong ratings, so that’s a good thing.

“Three years is on the outside of what we would like. But under the current market and circumstances, it’s still in the range of what’s being acceptable for us. Over the past couple of years, with the deteriorated market conditions due to the low volatility, we have done some 36-month deals.”

The combination of a reasonably high leverage factor with no limit on the upside makes the notes particularly appealing to this adviser.

“What’s really interesting is that although you don’t have downside protection, you get 1.5 times the upside uncapped. That’s very powerful,” he said.

A comparison to a long-only position in the S&P 500 index is favorable to the notes, he added.

“This note is tied to an index that’s virtually in every portfolio. The U.S. large-cap exposure is a very important asset class. This benchmark is a core position in a client’s portfolio,” he said.

“If you own the asset class anyway and believe in the creditworthiness of the issuer, it’s very powerful because you’re not taking any more risk on the downside and you’re getting 1.5 times the return of the index.”

Foldes downplayed the notion of liquidity risk associated with structured notes, including this one.

“Some people may argue that three years does not offer a lot of liquidity. We disagree,” he said.

“We have found since [we began] doing structured notes in the summer of 2008 that when we wanted to redeem the note prior to maturity, we were able to sell it to the issuer. They’re pricing every day. Every single day they will give you a price based on the value of the asset class and the options price relative to the term to maturity. We found that the pricing has been consistent, so we don’t really see the lack of liquidity as a serious concern.”

Rather than lack of liquidity, Foldes stressed two other “issues” when one compares a three-year note to a long equity position. In the case of this product, his conclusion is that the notes offer more value than the index.

Credit, dividends

The first “issue,” he said, is the creditworthiness of the issuer.

“After all, you’re buying an unsecured obligation guaranteed by the balance sheet of the issuing bank. If a bank goes out of business, you are at risk of losing your principal and return. We’ve seen that with Lehman Brothers. But as banks’ balance sheets have improved, we haven’t had a great concern about the creditworthiness of the banks that we use. We use only a handful of issuers, and RBC is one of them,” he said.

The second issue is dividends, which investors in structured notes, unlike shareholders, are not entitled to receive, he said.

The dividend yield of the S&P 500 index is 1.85%, which over the three-year period would be roughly the equivalent of losing 6% on a compounded basis.

“So you’re short 6% due to the loss of dividends. Let’s weigh the loss of dividends versus the 1.5 times upside. I’ll take the 1.5 times every day of the week,” he said.

“If over a period of three years your note gave you less than 6%, then perhaps you should reconsider the trade-off. But that would be a very flat market. Historically, the S&P 500 has averaged 10% a year. So clearly if you go by the average return, what you get with the leverage is a lot more than the dividend yield.”

For investors who intend to get exposure to the S&P 500 index, the notes offer a competitive alternative to an index fund, he said.

“It has compelling features. Three years is not too long. One-and-half times is nice leverage. And of course, the uncapped upside is really enticing, especially if you have a strong run. If you put together three years of return at that 150% participation rate, it becomes a very compelling value,” he said.

“If you’re long the S&P, there is no downside protection. So you’re not giving up anything really.

“Basically this is something that we, as a firm, would absolutely approach because we find the terms compelling.”

RBC Capital Markets, LLC is the agent.

The notes will price and settle in August.

The Cusip number is 78010UU96.

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