RBC’s buffered enhanced return notes linked to S&P 500 offer defensive play, accessible cap

By Emma Trincal

New York, Oct. 20 – Royal Bank of Canada’s 0% buffered enhanced return notes due Oct. 31, 2019 linked to the S&P 500 index offer investors a modest yet easily achievable cap, said Suzi Hampson, structured products analyst at Future Value Consultants. The buffer on the downside contributes to make this product a viable option for risk-averse investors, she added.

The payout at maturity will be par plus 150% of any index gain, up to a maximum return of 15%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to the 12.5% to 13.5% buffer and will lose 1% for every 1% decline beyond the buffer, with the exact percentage to be set at pricing.

Lower risk

“This is definitely a defensive product. The buffer is quite high compared to other two-years that have either no buffer or a 5%, maybe 10% at the most,” Hampson said.

For the purpose of running her report, Hampson used a buffer level of 13%, which is at midpoint of the range.

“Investors may be looking at reducing volatility. You’re capping the upside and reducing the losses.

“The return is dampened at 15% over two years. But that’s the point: no big highs and no big lows.”

Future Value Consultants produces stress test reports for structured notes providing its clients with simulation and back testing. The analysis delivers probabilities of occurrence for mutually exclusive outcomes, which vary by structure type.

This type of note shows four different outcomes. There can be capital loss; full capital return when the index decline is within the buffer zone; positive return when investors receive less than the maximum return; and maximum return when the return hits the cap, as illustrated in the investor scorecard, one of the report’s tables.

Modest expectations

“Because the maximum return of 15% over two years is not particularly aggressive, your return is very likely to be capped out,” she said.

In the neutral scenario, this probability is more than 38%.

The Monte Carlo simulation is run on a hypothetical “neutral” market scenario for some key sections but the firm also shows four different scenarios. Those are: bull, bear, less volatile and more volatile.

The chances of getting to the optimal point increase to 58% in the bull scenario. The bear assumption shows a probability of only 19%.

“There’s no big surprise here. The bullish scenario is the one in which you would expect the highest return,” she said.

The 15% cap over two years makes for a 7.25% annual compounded return, she noted. This result is achievable if the S&P 500 index is up by only 4.9% a year.

“This is quite restrained, which is why your chances of hitting the cap are quite high,” she said.

“When you combine this relatively low cap with the gearing, even though the gearing itself isn’t that high, you get to a point where the product starts to look a little bit like a digital. Either you’re capped out or you’re not.”

The middle-ground scenario in which investors receive a positive return below the cap happens nearly twice less often than “capping out,” as this outcome shows a probability of nearly 20% in the neutral scenario.

Close to the top

The low cap combined with the leverage also contributes to increase the average payoff in relation to the cap, she said.

While the maximum return scenario naturally coincides with a 15% average payoff, the “less-than-the-cap” positive return represents a “decent” average payoff of 11%, she said.

Adding the two positive outcomes – capped gain and gains below cap – generates another outcome called “return more than capital,” displayed in a separate table. It shows that investors will be “in the money” 58% of the time. This probability estimated for the neutral scenario rises to 74% in a bull market and drops to 41% in the bear market.

Growth assumptions

It may be counterintuitive to see the bear scenario yielding a positive return outcome 41% of the time, said Hampson. But it is only the result of the firm’s conservative methodology when it comes to estimating rates of growth and return outcomes, she explained.

The expected return of each underlying asset is given by the risk-free rate minus any dividends plus a risk premium proportional to the volatility.

The firm then calculates simulated returns on the basis of growth rates assumptions and volatility levels.

Those rates of positive and negative returns are subdued by default. For instance, the growth rate in the bull scenario used in the model is only 5.4%, according to the report.

For the bear scenario, the “growth” rate is minus 5.1%.

Naturally it is in the bear scenario that one finds the greatest chances of capital losses, which are triggered when the index falls by more than 13%.

Such outcome will happen 23% of the time in the neutral scenario versus 12% in the bull and 35% in the bear.

Back testing

Back tested results displayed in separate sections of the report show the product in a very positive light given the magnitude of the U.S. bull market especially in the recent years.

For instance in the past five years, the product returned more than capital 100% of the time. This probability figure dropped to about 77% for the past 10 years and 15 years.

“This kind of product would have performed well in the bull market. We can see that the most recent years are the best because we’re far away from the impact of the 2008 crash,” she said.

On the downside, the back testing reveals the beneficial impact of the bull market combined with the important role of the buffer. The notes would have not lost any money over the past five years. The chances of losses in the past 10 and 15 years would have been in the neighborhood of 18%.

“This note is designed to reduce risk,” she said. “Rather than investing directly in the S&P, your return will be capped but you get this buffer which you wouldn’t have in a fund. The buffer has a major impact in reducing risk.

“In a slightly modest growth scenario, this note would appeal to some defensive investor who would want a target return with less risk.”

RBC Capital Markets, LLC is the agent.

The notes will price on Oct. 26 and settle on Oct. 31.

The Cusip number is 78013GKL8.

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