RBC’s $1.83 million buffered return notes on SPDR ETF basket offer energy bet via best-of

By Emma Trincal

New York, June 28 – Royal Bank of Canada’s $1.83 million of 0% buffered return notes due Feb. 27, 2023 linked to a basket of ETFs give investors a break from the common worst-of by overweighting the basket with the best performing underlying in a product known as a best-of for the name of the embedded option.

The basket is made up of the Energy Select Sector SPDR fund, SPDR S&P Oil & Gas Exploration & Production ETF and the SPDR Gold Trust, according to a 424B2 filing with the Securities and Exchange Commission.

The basket weights will be determined on the valuation date, Feb. 22, 2023. The basket component with the best percentage change will have a weight of 40%, the next weighted at 32.5%, and the least performing component weighted at 27.5%.

If the basket finishes at or above its initial level, the payout at maturity will be par plus the basket gain with a maximum return of 18.75%.

If the basket falls by up to 7.5%, the payout will be par.

Otherwise, investors will lose 1% for each 1% basket decline beyond 7.5%.

This type of structure is based on a best-of option, a basket option that offers a payout based on the various levels of performance of its components.

Different

“It’s certainly interesting. I haven’t seen a best-of before,” said Jerry Dawson, director of investment research at Quest Capital Management.

“Complexity is always an issue for me. Here there’s a little bit of complexity but the outcome is pretty favorable, and the level of complexity is not that high.

“It’s better than an equally weighted basket. It’s a better risk-return.”

The underlying assets – two energy stock funds and a gold fund – offered a specific defensive strategy in his view.

“I see this as an inflation play,” he said.

“If you’re bullish on inflation, this is a pretty reasonable way to do it.

“You get the benefit of diversification with the bigger allocation to the highest return.”

Dividends

Investors as always when buying a structured note must give up dividend payments.

“Two of those ETFs are not a big deal. The other one pays a much higher dividend, so you give up a little bit more,” he said.

He was referring to the Energy Select Sector SPDR fund, which yields 3.84%.

This ETF pays a high dividend because its two top constituents are high-paying dividend stocks – Exxon Mobil Corp. and Chevron Corp. Together the two holdings make for nearly 44% of the fund’s portfolio.

The SPDR S&P Oil & Gas Exploration & Production ETF pays a lower dividend yield of 1.41%. The SPDR Gold Trust offers no dividend.

“Even if you’re giving up some of the income, you’re compensated by the 7.5% buffer,” said Dawson.

Inflation hedge

This adviser said rising prices pose a risk to the markets.

“While the debate is whether inflation is transient or not – the Fed says yes – my sense is that there is a pricing pressure, which is not necessarily only the result of supply and demand imbalances. In the end, with $3 trillion injected in the economy, we’ll see higher prices than during the pre-Covid period,” he said.

“This note has two energy funds. Energy should be a good hedge against inflation.

“There is also value in the space.”

He said he also likes gold.

“It’s not so much about inflation. But it’s a risk-off instrument if we get into the opposite scenario: a deflationary environment,” he said.

“The structure seems appealing to me, and it doesn’t look like you’re giving up a lot.

“If you’re optimistic about the underlying – in this case, I am – it should be a good addition to the portfolio.”

Not real allocation

Steven Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management, had a different opinion.

“You’re giving up a lot for a 7.5% buffer,” he said.

He said he liked the issuer’s credit and the shorter term of the notes, but not the structure.

“The benefit of a structured note is to be able to express a view on a specific asset class or market.

“Here they’re throwing three different ETFs, which have a negative correlation to one another. All you get is a decreasing weighting as the performance declines.

“I don’t see much return enhancement in there.

“And it’s not what I call asset allocation. I’d rather pick the view that I like,” he said.

Opportunity cost

The two energy ETFs have a 0.98 coefficient of correlation to one another. But their correlation with the gold ETF is slightly negative.

“I don’t need a structured note to be fabricated only to give the best performer a slightly greater weighting. The buffer is too small to be considered as a benefit. And you’re giving up substantial dividends on some of those energy funds,” he said.

Foldes said he “doesn’t like” worst-of structures. But he would consider them if he received “significant leverage or downside protection.” This best-of note offered none of these two benefits, he said.

The idea of weightings increasing with the performance was not a bad concept, he said. But the allocation percentages failed to provide a real incentive to buy the notes.

Stretching the gap

“You get 27.5% on the worst one and 40% on the best one. That’s not such a big deal.

“There isn’t an enticing difference in weighting between the two. Give me 0% allocation to the worst one and 60% to the best one, that would be a different story,” he said.

If the gap between the lowest and the highest weighting was substantially wider, the buffer may not even be necessary, he said.

There is only a 5-percentage points difference in weighting between the least and second performing fund and a 7.5% difference between the best and second-best returns.

“These differences are not significant enough to make the note compelling, he said.

The buffer size did not offer any intrinsic value, he added.

“I can do away with a 7.5% buffer.”

Foldes would consider a variation of the notes if the exposure consisted of U.S. or international equity indexes. In addition, the weighting associated with the worst performing fund should be close to 0% and the allocation to the best one would have to be raised to a much greater percentage than 40%.

RBC Capital Markets, LLC is the underwriter.

The notes settled on Friday.

The Cusip is 78016EBV8.

The fee is 0%.

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