RBC’s absolute return step notes tied to S&P 500 are too long, defense overdone, sources say

By Emma Trincal

New York, Aug. 27 – Royal Bank of Canada’s 0% trigger absolute return step securities due Aug. 31, 2023 linked to the S&P 500 index show too much downside protection and a pointless absolute return feature for a note of that length, advisers said. As the bull market continues to post new highs, some advisers expect more competitive returns, especially over long investment timeframes.

If the final index level is greater than or equal to the initial level, the payout at maturity will be par of $10 plus the greater of the step return and the index return, according to an FWP filing with the Securities and Exchange Commission. The step return is expected to be 24% to 28.8% and will be set at pricing.

If the final index level is less than the initial level but greater than or equal to the downside threshold level, 75% of the initial level, the payout will be par plus the absolute value of the index return.

If the final level is less than the downside threshold level, investors will lose 1% for every 1% that the final level is less than the initial level.

A new S&P

“The only thing that concerns me is the timeframe. Five years is a very long time in the current market,” said Carl Kunhardt, wealth adviser with Quest Capital Management.

Any investment in the S&P 500 index requires a close attention to the dividend yield, which is not paid to the noteholders, and to the price-to-earnings ratio, he said.

But the two fundamental metrics are about to change, he added. The S&P Dow Jones is modifying the sector classification of its indexes. The revised Global Industry Classification Standard (GICS) will be implemented at the end of next month.

Watch those metrics

“It could change the yield of the S&P and it could also change the P/E,” he said.

The changes will modify the definitions of sectors resulting in different classifications for some of the most-frequently traded names.

For instance, telecommunication will be renamed communication services. This category will include the current telecommunication services stocks such as AT&T Inc. and Verizon. But the sector will be significantly broadened welcoming three other categories of stocks, such as media stocks from the consumer discretionary sector (Comcast Corp., Walt Disney Co. and Netflix, Inc.); former information technology giants (Alphabet Inc., Facebook, Inc. and Baidu, Inc.) and current e-commerce companies (eBay Inc. and Alibaba Group Holdings Ltd.).

“The whole benchmark is getting reconstituted. We’ve done some research. We expect a decrease in the yield for major categories. We also anticipate a higher P/E overall, which means greater volatility but higher potential for growth,” he said.

“The fact that this note is giving you a minimum return with uncapped upside makes it very interesting and potentially attractive.”

Just for the look

Less attractive in his view was the downside protection, including the absolute return feature over the five-year tenor.

“I don’t think the S&P is going to be negative at the end of five years,” he said.

“The downside protection is almost a moot point and so is the absolute return. I’m not sure there’s ever been any five-year term that ended negative. So, you really don’t need that downside... it’s just a feel-good,” he said.

“If you’re going to make the note that long, getting a higher return is more important than putting a barrier.”

Good upside

The step return of 24% to 28.8% could be improved. But even as it is, Kunhardt found it attractive.

“The idea of getting 5% per year uncapped is attractive, especially if you look at an index yielding less but with the volatility potentially higher, which means higher potential gains,” he said.

“It looks like an attractive note. But I couldn’t make a decision until I can get my arms around how the new S&P is going to work.”

Too long

Steven Foldes, vice-chairman of Evensky & Katz / Foldes Financial Wealth Management, said that despite the good credit of the issuer, he did not like the notes.

The 3.5% fee, as disclosed in the prospectus, was also “pretty high” for his taste, even on a five year.

“We don’t think it would solve what we’re looking for in a note,” he said.

“It’s a very long note. Having a downside protection on a five-year note seems not to be a good use of the money you need to invest in order to fashion a note that works for a client.”

Fundamentally bullish

The absolute return feature would be even less relevant.

“These are expansive features. Statistically, it’s very unlikely to get a negative return after five years. So we’d rather see a higher digital return instead.”

Foldes, who is bullish on U.S. equity, said he would be willing to give up the downside protection altogether.

“You can make the argument that we’re at all-time highs. But this market is quite strong because the economy is strong,” he said. He cited corporate earnings growth, which he expects to remain strong, reduced regulations and tax cuts, which have been “stimulative,” and a favorable interest rate environment.

“With these healthy fundamentals this bull market can continue to run for years,” he said.

The step return is attractive but not in a bull market, he noted, or at least not at the level cited in the prospectus.

“This is a very modest return over five years...maybe 4% or 5% annualized. Given that you have to sacrifice 10% in dividend for the five years, they’re not giving you a whole lot. I’d rather have some leverage to offset some of that loss,” he noted.

Back to the drawing board

A better proposal for Foldes would involve a complete makeover of the structure.

“Our priority would be to make it short-term. Two years,” he said.

“We would still need to keep it uncapped.

“If possible, we would want a higher step up. Whatever would be left over if anything would go into some leverage.

“We recognize that there would not be any money left for a downside protection. We understand that it’s more important to get some protection on a short-term note. But we would be OK with that. We are bullish.”

RBC Capital Markets Corp. and UBS Financial Services Inc. are the agents.

The notes (Cusip: 78014G468) will price on Tuesday and settle on Friday.

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