RBC’s buffered notes on Euro Stoxx bolster terms on the downside, aimed at nervous investors

By Emma Trincal

New York., Jan. 3 – Royal Bank of Canada’s 0% buffered absolute return notes due Jan. 31, 2028 linked to the Euro Stoxx 50 index provide unlimited leveraged upside. But the non-payment of dividends and the terms on the downside made it more attractive to skittish investors than to bulls, advisers said.

If the index return is positive, the payout at maturity will be par plus the index return multiplied by the upside leverage factor, which will be between 122% and 132% with the final level to be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index return is zero or negative but greater than or equal to negative 30%, the payout will be par plus the absolute value of the index return.

If the index return is less than negative 30%, investors will lose 1% for every 1% that the index declines beyond 30%.

Dividends vs. leverage

“That’s a pretty healthy downside buffer there. The duration is a little longer than we like, but I like the terms of the note,” said Tom Balcom, founder of 1650 Wealth Management.

“In this environment, people are more defensive, more skittish. We tend to always look for downside protection, and right now, our clients are also asking for it because of the volatility.”

The non-payment of the index’s dividends over five years was perhaps the single drawback, he said.

The Euro Stoxx 50 index yields 3.18% compared to only 1.75% for the S&P 500 index.

“That’s a lot of unpaid dividends, but you have the leverage,” he said.

“Assuming your leverage factor is 1.3x, you’ll break even with a price return of roughly 40% over the period. You may not get it. But you’d be pretty close.”

There was no way to predict whether the return enhancement would offset the “loss” of dividends over a five-year period, especially without knowing the final leverage factor, he noted.

Focus on the downside

“You might underperform the underlying because of the dividends or you may not. But if you do give up some return on the upside, you’re getting it back on the downside.”

The benefit of the 30% buffer was two-fold: protection and absolute return, he added.

With that type of downside structure, advisers can provide their clients a hedge for their portfolios, he said.

“I always like to complement a long-only exposure with a buffered note. We have two notes tied to the Euro Stoxx and both are buffered,” he said.

“We believe that European equity is an asset class, and we use those notes to partially hedge our long positions.”

Balcom said he gets his long equity exposure to the Euro Stoxx from a mutual fund and an exchange-traded fund.

“This note gives you substantial advantages on the downside while allowing you to fully participate in the upside.

“It’s a good trade,” he said.

Easy hurdle, entry point

Donald McCoy, financial adviser at Planners Financial Services, said the notes may not be worthwhile for investors seeking growth. But more conservative clients should benefit from it.

The leverage was likely to generate a return equivalent to the index’s total return, he said.

“If over five years you average 8% to 9% a year, your note will get the full total return. The Euro Stoxx doesn’t have to perform crazy good by any stretch to earn the dividend that you’re giving up,” he said.

Another benefit was the “discounted” price of the underlying index.

Most developed countries suffered market losses last year, including Europe. The Euro Stoxx 50 index dropped 18.5% in 2022, slightly outperforming the S&P 500 index, which lost 19.4%. However, when compared to the Dow Jones industrial average, which shed 8.7% last year, the Euro Stoxx underperformed by nearly 10 percentage points.

“You’re starting at a pretty decent entry point, especially with a five-year time horizon,” he said.

Market sentiment

The potential for gains on the upside was non negligible, he said, pointing to the uncapped leveraged return over a five-year term. But the absence of any dividends should be considered since European stocks pay higher dividends than their U.S. counterparts.

“Over a five-year period, you’ve got to ask yourself if it’s worth giving up the dividend in exchange for the kicker,” he said.

The note’s main advantage was its downside payout, as it combined a 30% buffer with absolute return.

“You also have to ask yourself: what’s the likelihood for the market to be down over the next five years?

“The positive side is getting that absolute return. If the Euro Stoxx is down between 0 and 30%, you’re going to make that return, which makes it very attractive to the moderately worried to the extremely worried client.

“And if you’re down 31% you only lose 1%. That’s the protection part.

“This is a note for investors who are very conservative or very pessimistic about the equity market over the next five years,” he said.

Bullish investors, despite the uncapped leveraged exposure, are unlikely to buy the notes, he said.

“You’re paying too much in giving up the dividends. If you’re bullish, you should just go long the index fund. This note is only for conservative or bearish investors, people willing to give up the dividends because they anticipate a negative outcome,” he said.

RBC Capital Markets, LLC is the agent.

The notes (Cusip: 78016HL65) will price on Jan. 26.

© 2015 Prospect News.
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