RBC’s $2.03 million leveraged notes tap into global markets via weighted index basket

By Emma Trincal

New York, Aug. 15 – Royal Bank of Canada’s $2.03 million of 0% buffered enhanced return notes due Aug. 13, 2027 give investors a chance to bet on a weighted basket of global indexes, which is not the norm. Most notes tied to baskets of indexes tend to give exposure solely to non-U.S. markets or sometimes to U.S. indexes but rarely to both, according to data compiled by Prospect News. The most commonly used unequally weighted basket of indexes reflects the equity returns of the euro zone, the U.K., Japan, Switzerland and Australia, the data showed.

The basket for this note allocates about two-thirds to U.S. benchmarks and one-third to international markets. It consists of the S&P 500 index with a 43.75% weight, the Russell 2000 index with a 21.25% weight, the MSCI EAFE index with a 22.5% weight and the MSCI Emerging Markets index with a 12.5% weight, according to a 424B2 filing with the Securities and Exchange Commission.

If the basket return is positive, the payout at maturity will be par plus 135% of the return.

Investors will receive par if the basket declines by 10% or less and will lose 1% for every 1% that the basket declines beyond 10%.

Novices in the field

Jerry Verseput, president of Veripax Wealth Management, said the notes may be useful for inexperienced investors in structured notes.

“I wouldn’t use it but it’s because I’d rather target specific notes for the specific indices. You get a little bit more control that way,” he said.

“It’s kind of a one stop-shop for a whole portfolio. You’re going to beat the indices on the downside and on the upside. From that standpoint, I like it.

“For someone who is not used to buying notes, it seems like a viable solution.”

One-year call

In order to get exposure to the basket, Verseput would modify some of the terms.

“It’s a five-year no cap. I would look to add a one-year call, so I get more leverage. It may not work for someone with little experience in structured products. This note is designed to be a simple note. Probably a pretty good starter,” he said.

The one-year autocall he mentioned referred to a type of growth note that offers uncapped participation at maturity and a one-time automatic call feature at the end of the first year. Access to the upside return is therefore not just limited by the direction of the market but also by the possibility of an early redemption, which would give investors in place of uncapped gains at maturity a fixed call premium. The structure allows for the pricing of the unlimited upside, which often comes with significant leverage.

Dividends

“The 10% buffer is decent. But you have to look at the blended average yield. You may actually have more than the 10% buffer just from the dividends,” he said.

Over the five-year period, the weighted average of the dividend yields is approximately 8.65%.

“The 10% buffer is not buying you much more than the dividend yield,” he said.

“The 35% on the upside however, given that there is no cap, gives you more than the dividend. That’s definitely more successful.”

Verseput would rearrange the note to make the payout more appealing compared with a long position.

“I don’t see where the note buys you a lot of improvement,” he said.

“I would add the call feature after one year to get either more buffer or more upside leverage.”

Exposure, buffer

Carl Kunhardt, wealth advisor at Quest Capital Management, said the combination of U.S. and international indexes can be beneficial to investors.

“These weightings are pretty close to the actual percentages you find in global equity indices. The note is a bet on global equity using very broad indices,” he said.

Assessing the risk of principal loss should be the first “decision point,” he said.

In that regard, he said he was comfortable with the downside protection.

“I like the 10% buffer a lot. It’s a hard protection, not a barrier. And there is no gearing, no gimmick,” he said.

Kunhardt said that five-year rolling periods were likely to reveal the strength of the buffer.

“I don’t have the stats in front of me, but I’m willing to bet that the chances of that basket to lose more than 10% over five years are close to zero, if not zero,” he said.

One caveat was the five-year term, he noted.

“Despite the market rebound, we’re starting at lower levels. Both the S&P and the Russell are still down 10% year to date. In five years, we could recover and fall back into the next cycle.

“I don’t buy notes greater than five years. Five years is the longest I go out,” he said.

Correlations

But the note offers other benefits, which made it attractive.

“I like the global equity exposure. That’s an advantage. Assuming the normal correlations are maintained, non-U.S. stocks tend to follow U.S. stocks 12 to 18 months later. That’s why the combination works,” he said.

“When the U.S. is declining, non-U.S. markets are at their peak. The opposite is true too. The longer these correlations continue to hold, the better for that kind of portfolio.”

Home, sweet home

The geographic breakdown with two-thirds of the basket consisting of U.S. indexes and one-third of non-U.S. markets was not unusual, he explained. In fact, it was expected.

“It makes sense. The actual equity market is a bit more balanced, more like 48% U.S. and 52% non-U.S. But the basket is not totally out of whack,” he said.

“In every country, there is a home bias to the country allocation.

“U.S. portfolios always overweight the U.S.

“U.K. portfolios always overweight the U.K.

“It’s just a natural human instinct. The home bias holds across any market.

“So, the fact that the U.S. is overweight in this basket is actually pretty normal.”

Beating the market

The terms of the deal were attractive.

“What type of return can you expect to have five years out? Trying to guess the answer to this question is a fool’s errand,” he said.

“But the important thing is the combination of leverage and no cap. If there is a market upside, I’m participating in it, and I’m also outperforming the basket.

“On the downside I have a 10% safety net. If I fall less than 10%, I’m getting my money back. It’s an opportunity cost but it’s not a loss of money.

“It’s a very simple strategy. It’s an easy-to-understand structure. No games. I like it.”

RBC Capital Markets, Inc. is the selling agent.

The notes settled on Monday.

The Cusip is 78016FRA4.

The fee is 0.25%.

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