RBC’s contingent coupon autocalls on Wells Fargo offer alternate to typical index worst-of

By Emma Trincal

New York, Jan. 15 – Royal Bank of Canada’s autocallable contingent coupon barrier notes due Jan. 19, 2023 linked to the common stock of Wells Fargo & Co. offer investors a different risk profile from a direct long position in the stock; for income seekers, the single-stock underlier also presents an alternative to the common worst-of on indexes with a greater likelihood of automatic call, said Suzi Hampson, head of research at Future Value Consultants.

Each quarter, the notes will pay a contingent coupon at the rate of 10% per year if the stock closes at or above its trigger price, 70% of its initial price, on the observation date for that quarter, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par if the stock closes at or above its initial share price on any quarterly observation date.

If the notes are not called, the payout at maturity will be par unless the stock finishes below its 70% trigger price, in which case investors will be fully exposed to the decline.

Volatility

“This is not Tesla or Amazon. Still, the implied volatility is considerably higher than most equity indices,” Hampson said.

The two-year implied volatility of the underlying stock is 34.61% compared to 21% for the S&P 500 index.

The premium generated by the issuer comes essentially from the volatility, she said. The role of the dividend is limited given that the yield is only 0.71%.

“You’re not getting the 10% coupon from the dispersion between two or three indices here,” she said.

“Perhaps this is what makes it more appealing to some investors.

“The concept of correlation is quite complex to get a handle on.”

But each investor is different.

“Others are not willing to take the risk of a single company. They prefer to invest in three big indices they know even if correlation is more difficult to understand than volatility when you try to assess the risk.

“It works both ways. It’s a matter of preference.”

Stress testing

The notes are designed for income. Most autocallable investors seek an early exit, she said.

“The 10% coupon is appealing,” she said.

“You’re more likely to get 2.5% after three months and most investors would be happy with this outcome. After all, it’s still 10% annualized.”

To analyze the probabilities of calls at different observation dates as well as other outcomes such as loss of capital at maturity, Hampson ran a research report on the notes based on Future Value Consultants’ stress-testing model.

The probabilities are calculated from the results of a Monte Carlo simulation under a neutral assumption, which is the base-case. The neutral scenario reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

Call at point one

The model found that the notes will be called on the first observation (in three months) 48.44% of the time.

“Intuitively, your chances for the stock to be up or down should be 50/50 on the first call point since the growth rate is zero under the neutral assumption,” she said.

“In this case it’s a little bit lower because the forward is slightly negative.”

The forward price reflects the expected value of the underlying.

It is measured as the risk-free rate minus the dividend yield of the underlying, she explained. Since the 0.71% yield is higher than the risk-free rate, the forward is “slightly” negative.

“What it means is that the note is less likely to be called since the market does not expect the value of the underlying to grow,” she said.

“This is why the chance of a call is slightly less than 50%, she added.

She stressed however that the probability of a first call is not significantly lower than 50%, simply because the forward price is only slightly negative.

A call “at point one” would be even less likely with a worst-of, she noted.

“In general, the probability of a call is much lower with a worst-of since you need all three underlying to be flat or up,” she said.

“The chances of calling with this note are a little bit better. So even though volatility is quite high, it doesn’t impact your chances of calling.”

However, it will impact the chances of losing capital at maturity, she noted.

Negative outcomes

The Monte Carlo simulation showed a 17.58% probability of a barrier breach.

“That’s relatively high. If you haven’t called, you’ve been below 100 every quarter for two years. Your chances of being below the barrier therefore are very high,” she said.

Another outcome worth looking at, she said, is the “no call will occur” bucket. Such outcome is associated with a 25% probability.

This particular outcome can be split into two different ones, she explained.

Either the barrier is breached, which happens 17% of the time, or the barrier plays its role, protecting investors when the stock declines within the protection range.

The probability of benefiting from the barrier is simply calculated by subtracting the probability of a breach from the probability of “no call occurs.” The result: the barrier will be used 8% of the time.

“This gives you an idea of the value of the barrier. It will help you less than 10% of the time, which isn’t huge,” she said.

“At first glance a 70% barrier seems quite good. But if you don’t call, your chances of losing capital are substantial.”

The consequence of the breach are heavy losses. In the event of a decline below the barrier level, the average loss will be 44.5%.

“At the same time, you get a 10% coupon. You have to pay for that,” she said.

Risk mitigation

Investors should not limit their risk evaluation of an autocall to the barrier level, she noted.

“This is quite a transparent product,” she said.

“Because the structure is built on a single asset, investors need to be familiar and comfortable with the stock.

“If you call, you get your money back. The autocall is a big risk-reducing element of the product and it is true of any autocall. With this one, you will kick out three quarters of the time.

“This is a product that works best in a sideways market. It’s another way to get exposure to the stock using a different risk profile.”

RBC Capital Markets, LLC is the underwriter.

The notes were expected to price on Jan. 13 and settle on Jan. 19.

The Cusip number is 78013GF91.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.