RBC’s $1.38 million digital notes on MSCI EAFE may be used to hedge international bucket

By Emma Trincal

New York, Jan. 19 – Royal Bank of Canada’s $1.38 million of 0% digital index-linked notes due March 8, 2024 linked to the MSCI EAFE index will outperform the most in a negative market, making the investment suitable for bearish investors seeking to hedge some of the international equity portion of their portfolio, said a financial adviser.

If the index finishes at or above 85% of its initial level, the payout at maturity will be $1,118.50 per $1,000 principal amount of notes, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will lose 1.1765% for every 1% that the index declines beyond 15%.

Fundamentals

“Even if the index is down 15% you can outperform significantly by capturing that digital,” said Steve Doucette, financial adviser at Proctor Financial.

“It’s definitely more attractive if you’re a bear.”

Despite the headwinds faced by Europe, the EAFE has been rallying since last fall, he noted.

The MSCI EAFE index tracks the returns of developed markets and European stocks represent 63% of the index.

“Europe, after a terrible performance for years, is finally outperforming the U.S. I’ve been predicting this for some time. It’s finally happening,” he said.

The MSCI EAFE index is up 7% year to date while the S&P 500 has only gained 2.4%. Last year, the S&P 500 index fell by 18% and the MSCI EAFE index dropped 14%.

“This is why I like to think of fundamentals. Why is the EAFE beating the S&P right now? Because fundamentals matter. A reversion to the mean was well overdue. Now it’s in a momentum but fundamentally, it’s still cheaper than the U.S,” he said.

Not a bullish play

The payout had a bearish tilt, said Doucette. By virtue of the booster, the notes will offer more value if the index declines by 15% or less than if it finishes positive.

“Even if you go down beyond the buffer, you’ll still beat the index.”

Investors have to be “bearish or just moderately bullish” in order to outperform, he added.

“You just can’t be really bullish because the digital is going to cap you at 12%. If you’re an absolute bull, you extend the maturity a few years and you lever up the upside,” he said.

For Doucette, the notes could be used as a hedge.

“You could take a little bit of your international equity allocation and buy this for the protection on the downside if you think the market could be down. You’d have the potential for a significant outperformance.

A 15% decline in the index would generate an excess return of nearly 27 percentage points, he noted.

Headwinds

A case can be made for downside protection and hedging when investing in developed markets, especially in Europe where growing geopolitical and economical risks are being felt, he noted.

“You have Ukraine. It’s a major geopolitical risk. On the economic front, the E.U. is also increasing rates. In fact, most central banks are,” he said.

The Bank of England, the Reserve Bank of Australia, Norway’s Norges Bank, the Bank of Canada and the Swiss National Bank all increased their benchmark rates last year. All those countries except Canada are represented in the MSCI EAFE index.

“The Fed is still fighting inflation. We don’t know how long it will last and what’s going to happen with the economy.

“If we have a recession here in the U.S., Europe will be hit just as hard.

“I guess there are a lot of headwinds. That’s why it makes sense to take some of your international exposure off the table and use this note as a hedge. That’s how I would do it,” he said.

Too short

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the terms were acceptable. But he objected to the 14-month tenor.

“Because it’s such a short-term note, I’m not super excited about it. The short duration as well as the volatility of the underlying index make this investment a little riskier than I’m comfortable with,” he said.

He pointed to a number of risk factors pertaining to Europe.

“First you have the war in Ukraine. We don’t know for how long. This war has triggered a serious energy crisis in the entire continent. We’re still in the middle of winter. Europe is facing energy shortages and rising energy costs, all sorts of issues that could create a recession. Meanwhile Europe is lagging the U.S. in the tightening of their monetary policies.

“Long term, I’m optimistic about the notes. But short-term, I want a little bit more security,” he said.

RBC Capital Markets, LLC is the agent.

The notes will settle on Friday.

The Cusip number is 78016HN89.

The fee is 0%.

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