RBC’s absolute return notes linked to Dow industrials express variety of views, sources say

By Emma Trincal

New York, Feb. 11 – Royal Bank of Canada’s 0% absolute return notes due Feb. 22, 2019 linked to the Dow Jones industrial average could appeal to slightly bullish or slightly bearish investors, sources said.

Also known as non-directional, the notes are usually aimed at investors trying to generate gains both on the upside and the downside and within a range.

If the index return is positive, the payout of the notes at maturity will be par plus the index return, subject to a maximum redemption amount that is expected to be 118% to 122% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index falls by up to 20%, the payout will be par plus the absolute value of the index return.

Otherwise, investors will be fully exposed to any losses.

Range

Steve Doucette, financial adviser at Proctor Financial, who uses structured notes to outperform the market in both directions, was not attracted by the upside potential. Rather than being undecided about the future direction of the market, an investor in the product would have to have a strong level of conviction about the index finishing within a range, which he said was narrow.

“The only time you’ll outperform is if it’s between zero and minus 20%. That potential outperformance is huge, but you still have downside risk and you’re capped,” he said.

“You have to be very confident that the Dow will fall by less than 20% on the downside. That’s the only way you’re going to win.”

Risks

In other scenarios – bullish or bearish beyond the barrier threshold – the risks or opportunity costs incurred by investors may be too high.

Part of the difficulty is predicting what the market will do in a three-year timeframe.

“On the upside, you could give up a big chunk of the return. Imagine that we’re now entering a bear market. Bear markets don’t last that long. Three years from now, you could have a strong rebound and your cap would hurt you.

“On the other hand, if what we have now is just a pullback, you could see the market coming back up and then we’re hit by a bear market just as we get close to the end. The 20% protection may not be enough in this scenario.”

The creditworthiness of the issuer is a plus, he noted.

“Royal Bank of Canada is a decent name. Canadian banks have been solid during the financial crisis. They are well capitalized,” he said.

“But why lock your money out in the notes if you can only outperform in a narrow range on the downside?

“It might be worth taking a little bit more credit risk with a U.S. bank and get better terms.”

Cap

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he liked the absolute return feature but was not necessarily comfortable with the type of protection used in the structure. The note is designed for investors lacking a clear directional view on the market.

“This type of note is down the middle of the fairway,” he said.

“You’re not getting a big return on the upside, but you can outperform on the downside. It’s not directionally dependent. You’re playing it safe.”

He liked the term. “A three-year note on the Dow is not unreasonable,” he said.

The main drawback is the limited upside.

“I’m not a fan of a cap on equity portfolios.”

The 6% to 7.5% annualized cap is within historical ranges of market average return looking back over long periods of time, he said. But as the market is now in correction mode, it is unclear whether such average equity returns are to be expected over the next three years, he explained.

The Dow since its peak in May 2015 has dropped more than 15%. It has already lost nearly 11% for the year.

Dual directional

The potential absolute return offers both advantages and risks, he noted.

“I do like the downside protection, but from my perspective, I would prefer a buffer because it gives me more dependability. I know my expectations. I understand what my risk is,” he said.

The appeal of the notes is the possibility of getting a positive return if the index finishes negative.

“The fact that the market has already seen a 15% pullback gives a decent entry point. The depth of a potential bear market is mitigated a bit because we’re not trying to price this thing at a high.

“I’m not necessarily excited about it, but it’s interesting.”

RBC Capital Markets, LLC is the agent.

The notes will price Feb. 17 and settle Feb. 22.

The Cusip number is 78012KLJ4.

© 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.