RBC’s $2 million buffered bullish notes tied to S&P would have benefited from higher cap

By Emma Trincal

New York, Dec. 15 – “This is a small issue. I suppose it was done specifically for a client, although I can’t really say because I don’t see those tiny deals,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

Royal Bank of Canada’s $2 million of 0% buffered bullish enhanced return notes due Dec. 14, 2017 linked to the S&P 500 index offered leverage and buffered protection, but the cap seemed to disappoint buysiders.

The payout at maturity will be par plus 125% of any index gain, up to a maximum return of 30%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 12% and will lose 1.1363% for every 1% decline beyond 12%.

“It’s not a bad little note although I have a personal bias. I don’t like leverage on the downside,” said Kunhardt.

“But, assuming the market falls by 38% in a 2008-like bear market scenario. With the 12% leveraged buffer, investors would lose 29.50% and not 38%. That’s an 8.50% excess return over the benchmark, he noted.

“You are getting a buffer effect even beyond the buffer, so it’s not so bad.”

Capped out

The main issue for Kunhardt was the upside.

“I don’t particularly like the cap,” he said.

“I acknowledge that you have to pay for protection and that the way to do that is by accepting the cap. I get that. But this is a 9% annualized cap. That’s less than the historical rate of the S&P. If we have just one year of a good run, that’s all it takes, you’ll blow that cap.

“Even with a year like this year, which is not a particularly good year, you are already above the cap. It looks like you’re betting against yourself here.

“Clearly, it’s a trade for somebody who has no conviction. They’re biased against the market. I’m just not sure why you would want to be in the market and give up most of the upside for that protection.”

The S&P 500 only needs to grow by 7.45% a year for investors to reach the maximum return, he noted.

“If you’re not that bullish, why would you get the exposure to the market to begin with?” he said.

On the other hand, Kunhardt said that the maturity was acceptable.

“It’s hard to find three years now. Notes are getting longer and longer. Three years, particularly in this market, is a nice, comfortable timeframe.”

Michael Kalscheur, financial adviser at Castle Wealth Advisors, agreed that the upside was problematic.

Two out of three

“The cap is good but it’s not great,” he said.

“In the past 35 years, the S&P 500 has generated a cumulative return of 30% or more over a three-year period.

“That means you have almost a 70% chance of exceeding this cap, based on statistical figures regarding the S&P 500 historical return.

“My test is very simple: are you winning two out of three times? Because here, it looks like the opposite: you have two-thirds of a chance of losing if you agree that underperforming the market is somehow a way to lose this game.

“Also, you’re not getting any dividends over three years. The leverage helps but it doesn’t fully compensate you for the loss of dividends until you hit the cap. And then, you’re capped. You can’t outperform the market.”

The downside protection was more attractive, as it enabled investors to outperform the index.

“I also like the fact that they chose 12% instead of 10%. How did they get 12%? I don’t know. It was probably the client. But I find it refreshing to be outside of the 10%, 15% box everybody seems to be locked into,” he said.

But Kalscheur looked at his three scenarios and found that “losing two times out of three,” did not meet his criteria.

“If the market is flat, I don’t win. If it’s bullish, I don’t win. It’s only if it’s down that I can perhaps win,” he said.

Tradeoff

Kalscheur said he would agree to extend duration in order to improve the upside.

“I’d like to see a better cap. A lot of other notes have uncapped performance. You rarely see them as three-year notes. But I’d rather have a five-year note uncapped than a three-year.”

Kalscheur said that “I can’t get really excited” about the cost of the notes.

The cost includes a 3% commission and nearly 1% in additional fees, he said, commenting on the prospectus.

“If the commission could be waived, I could get past the cost issue. But I still would have to get a higher cap.

“As it is, I would say, it’s not a bad note. But it just missed the mark for a consideration in our portfolio,” he said.

The notes (Cusip: 78010U7C5) priced on Dec. 10.

RBC Capital Markets, LLC is the agent.

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