RBC’s absolute return barrier notes tied to S&P 500 seen as attractive except for barrier type

By Emma Trincal

New York, Sept. 16 – Royal Bank of Canada’s 0% absolute return barrier notes due Sept. 29, 2016 linked to the S&P 500 index offer attractive terms, according to buysiders, but the trade-off consists in accepting a barrier that can be breached any time during the life of the notes, or a so-called “American barrier,” they noted.

A “barrier event” occurs if the index is less than the barrier level on any day during the life of the notes, according to an FWP filing with the Securities and Exchange Commission. The barrier level, 76% to 78% of the initial level, will be determined at pricing.

If the final index return is positive, the payout at maturity will be par plus the index return.

If the final index is less than or equal to zero and a barrier event has not occurred, the payout at maturity will be par plus the absolute value of the index decline.

If a barrier event has occurred, investors will be fully exposed to the decline of the index.

The notes fall into the category of absolute return notes also called “twin-win” as investors may gain from an index decline providing that the decline is limited to a specific range, explained Steven Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management.

On the plus side

“Twin notes are interesting and this one is interesting too because obviously two years is a short period of time and you have no cap,” he said.

“If the market is up you don’t miss any upside. This note would satisfy bulls as well as modestly bearish investors.”

He chose a hypothetical barrier level of 78%, which would give investors up to 22% of potential decline before triggering a barrier event.

“Even if we had a down market, investors could still make money as long as the S&P doesn’t drop by more than 22%.

“It’s a fairly significant decline. That’s a bear market. There is still a good amount of protection in terms of downside.

“There are a lot of attractive elements in this deal. The twin is attractive. The fact that it’s uncapped is also attractive because you don’t get penalized if the market has a strong run.

“Clearly RBC is an issuer that has a lot of credibility for us and a lot of financial strength. It’s one of the banks we do business with.

“You lose the dividends but that’s true with any other structured note. With the S&P yield at 1.80%, you give up that dividend for two years. It’s still a solid note. It’s not too long, it’s uncapped; it has a 22% downside protection,” he said.

Poor timing

Dean Zayed, chief executive of Brookstone Capital Management, said he did not find the deal very timely.

“Historically, on average we have experienced a correction of 10% or more about every 12 to13 months,” he said.

“We all know we are overdue for a correction. I do not like this note given the frothy level of the market currently and the fact that I believe there is a high amount of certainty we will have a greater than 10% correction during the duration of these notes, over the next two years. When and how much will it correct is an unknown but that probability as we calculate it, is not worth the risk of losses that this note has nor is it worth the unlimited upside and absolute return feature.

“The timing of this note is just not so favorable,” he said.

Customizing the deal

Despite the notes’ appealing features, Foldes said the type of protection would have to change in order for his firm to consider the investment.

“The weak aspect of the structure is the barrier type. Obviously an American barrier does not offer the same level of protection than a European barrier,” he said.

European barriers are observed only once, at maturity.

“If I had to customize that note to make it a little bit more attractive, I would suggest a couple of changes,” he said.

“I would prefer to have a European barrier and possibly a bigger one. I like the two-year and I like the no-cap. But as a trade I would be willing to give up the win on the downside.

“For instance I would consider a 30% European barrier without the twin-win feature,” he said.

He explained why based on a hypothetical 78% barrier level.

Managing expectations

“Imagine that at some point, the barrier is breached. The index drops 23% for instance. But at maturity, the index ends down 15%. Even though the client finished well above the 22% barrier, they are going to lose 15% of their principal while they expect to lose nothing only because at some point in the past, the index broke the barrier,” he said.

“It’s a very difficult conversation to have. That’s the problem with American barriers. If I had the same level with a European barrier and assuming the index is down 15% at maturity, my client would lose nothing.

“The American barrier is not nearly as attractive as the European barrier.

“The market is so volatile, you’re much better off having to only worry about that last day.

At the same time, Foldes said he understood why the issuer had been able to eliminate the cap, keep the tenor short, use a less volatile underlying and still offer protection and absolute return.

“Obviously the American barrier helps a lot with pricing,” he said.

“I can’t say for sure that I would get the European barrier in addition to more protection while maintaining the uncapped upside. It’s a function of what I would be giving up. Perhaps I would have to give up more than the twin win. Perhaps I would have to extend the duration. I wouldn’t mind going from 24-month to 30-months for instance. It would be a conversation to have with RBC. What is really important to me is the uncapped S&P 500 and some measure of protection and from my clients’ perspective, a barrier that strikes only once, at maturity is what I would expect to have,” he said.

The notes (Cusip: 78010U2D8) are expected to price Sept. 25 and settle Sept. 30.

RBC Capital Markets, LLC is the agent.

© 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.