RBC’s autocallable buffered absolute return notes on SPDR S&P 500 ETF seen as bond substitutes

By Emma Trincal

New York, Nov. 14 – Royal Bank of Canada’s 0% autocallable buffered absolute return notes due Nov. 29, 2024 linked to the SPDR S&P 500 ETF Trust could offer either bond or equity returns. But advisers would allocate the notes to the fixed-income part of their portfolio based on probabilities of outcomes.

The notes will be called automatically at par plus 5% if the ETF closes at or above its initial price on Nov. 29, 2023, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not called and the final ETF level is greater than or equal to its initial level, the payout at maturity will be par plus the ETF return.

If the ETF falls by up to 30%, the payout will be par plus the absolute value of the return.

Otherwise, investors will lose 1% for every 1% decline beyond the 30% buffer.

Likely call

Scott Cramer, president of Cramer & Rauchegger, Inc., said that the most favorable scenario was also the least probable.

“This is one of those notes where things look good on paper, but in reality, you’re not going to do very well,” he said.

The best outcome occurs at maturity if the notes do not get called after a year, he added.

“That’s when you can do really well. But things would have to go absolutely right,” he said.

The odds are stacked against investors, he said.

“After one year, it’s more likely that the S&P will be higher. Therefore, the chances of being called are extremely high. If that’s the case, your return is limited to 5%. As an equity proxy, this note doesn’t offer any satisfying result,” he continued.

A real equity scenario would happen if the notes do not get called after one year.

“You’ll make money both on the upside and on the downside, as long as the index is not down more than 30%. You could even earn up to 30% if the index goes down by the same amount,” he said.

“Chances are it’s not going to happen.”

Two outcomes

Since many investors divide their portfolio between equity and fixed-income, putting the notes in the right place may be challenging given the hybrid nature of the payout.

“As a bond proxy, you’ll end up getting 5%. There’s more risk than Treasuries if you don’t get called, but the risk is also reduced by the size of the buffer. And unlike Treasuries, you have a chance to get some attractive upside.”

While no one can predict in advance whether the return is going to be the call premium, which would satisfy the requirements of a bond portfolio, or the equity return with unlimited returns on the upside and up to 30% of gains on the downside, the probabilities of outcomes should be what investors need to consider when making their allocation decision.

Bond-like

“It’s more of an alternative to bonds than to stocks just because it’s more likely that you’ll get called in one year than not. And 5% is not an equity return,” he said.

“Don’t get me wrong: there is still risk. If you pass the one year without getting called and the market drops, more than 30% at maturity you will lose some money.

“But I don’t think this is going to be the case. In two years, the market should be higher because a lot of issues will be straightened up by then.

“For a low-risk, bond-like allocation, yes, this is the right note. But not for growth.”

Better one before

On Oct. 28, RBC priced $12.5 million of nearly identical autocallable buffered absolute return notes on the SPDR S&P 500 ETF trust. The terms were exactly the same with one difference: the call premium was at 10.05%.

Cramer said he does not chase returns waiting for the market to offer higher premium.

“We don’t time the market. Either it’s a good deal today or it’s not. If you start to compare the terms of a deal that priced a month ago, you’re setting yourself up for regrets and envy and you end up making bad decisions,” he said.

Status quo

Carl Kunhardt, wealth adviser at Quest Capital Management, would also use the notes as a bond proxy.

“Part of investing is being able to play games. The game here is where you slot this note in your asset allocation.

“I wouldn’t use it in the equity part of my portfolio because I would be limiting my return on the near end with that call feature,” he said.

“The buffer and the absolute return are very attractive but it’s irrelevant if you don’t get passed the first year.”

Looking at the macroeconomic picture for the next 12 months, Kunhardt concluded that the market was more likely to be up than down.

“By next November, volatility should have subsided by virtue of a divided government. Wall Street likes divided governments because things are more predictable. Why? Because nothing much is going to happen. Most forecasts see an improved market as we get into the summer. People think the Fed will have slowed down the pace of rate hikes by then,” he said.

Kunhardt also expected the call to materialize easily.

“All you need is the index to be at zero in one year. You should definitely be called with a 5% return. That’s not an equity return, and you have the reinvestment risk,” he said.

“I would much rather use one of those leveraged notes as an equity play, those that give me some participation.”

Bond replacement

But Kunhardt liked the notes as part of the fixed-income allocation.

“Now this is much more interesting. The 5% premium is going to give me something like a Treasury yield. If you get called, you know you’ll get your 5%. It’s like a bond.”

If the notes do not get called, some positive scenarios may unfold.

“The absolute return could really pay off. The 30% buffer is going to mitigate a lot of the risk. While I still have market risk exposure, the size of the buffer gives me a great deal of comfort,” he said.

Kunhardt added that he might consider putting a “small piece” of the notes in his fixed-income allocation.

“Am I playing a game with my allocation? Yes, since I don’t have any principal protection. But I feel confident enough to use it as a fixed-income substitute.”

The likely automatic call and the size of the buffer were two important risk mitigating factors behind his reasoning.

“I like the notes, but they’re not intended as an equity play. They’re a fixed-income play. Having a 30% buffer is a huge amount of protection. Without this buffer, I would probably have a different view on where the notes belong,” he said.

RBC Capital Markets, LLC is the underwriter.

The notes will price on Nov. 23 and settle on Nov. 29.

The Cusip number is 78016H4T4.

The Cusip for the previous deal, which priced last month, is 78016H2X7.

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