RBC’s buffered enhanced return notes tied to iShares real estate subject to interest rate risk

By Emma Trincal

New York, March 15 – Royal Bank of Canada plans to price 0% buffered enhanced return notes due March 31, 2020 linked to the iShares U.S. Real Estate exchange-traded fund, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 2 times any fund gain, up to a maximum return of par plus 20%.

Investors will receive par if the fund falls by up to 21% to 24% and will lose 1% for each 1% decline beyond the 21% to 24% buffer. The exact buffer will be set at pricing.

Yield versus cap

“I don’t think you’re getting enough upside because you’re giving up a high dividend yield,” a market participant said.

The iShares U.S. Real Estate ETF offers exposure to U.S. real estate companies and REITs sought after for their higher yields.

The fund carries a 4.11% dividend yield.

“You’re giving up more than 8% total. It’s two times up subject to 20%. Over two years, chances are you’re going to cap out. At less than 5% a year you’re capped out,” he said.

The maximum return provides investors with 9.55% per year on a compounded basis. Such result may be achieved with a very modest growth of the underlying at a rate of 4.88% per year.

This market participant compared the ETF payout, which includes the dividends but no leverage with the notes.

If the price return is up 10% over two years, a direct investment in the fund will generate 18% in total return, he said.

The notes will provide 20% with the double upside exposure to the price appreciation.

“But after that, you underperform, so I’m not sure it’s a great cap – not with the risk that you run.”

Interest rate risk

Apparently the 21% to 24% buffer is “great,” he said. But it may not be good enough.

Interest rate risk is a threat to most high-yielding asset classes.

“People buy real estate stocks for the yield. Anything high-yield whether you’re talking about real estate, [Master Limited Partnerships] or utilities is going to take a beating when rates are up.

“The two-year [Treasury] is now at 2.85%. It’s going to be up to 3% this year, probably 3.5%.

“Wouldn’t you rather own risk-free bonds than an ETF?

“Despite the 24% buffer, I still think there’s plenty of risk in this note,” he said.

Too much protection

An industry source disagreed. In his view, the issuer spent too much on the downside protection. More money should have been allocated to the upside, he said.

“20% sounds pretty good. But you’re not getting dividend. You’re giving up a lot and rates are still low,” this source said.

Looking at the dividend yield and the two-year swap rate, he said that the forward was cheap.

A lower forward cheapens the cost of putting the structure together.

In addition, the volatility of the underlying at 13.6% was not very high.

“When volatility is low, you’re not going to go below the buffer. You don’t really need that much.”

RBC Capital Markets LLC is the agent.

The notes will price on March 26 and settle on March 29.

The Cusip number is 78013XHJ0.

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