RBC’s $1 million bearish digital notes on S&P 500 to offer various ways to bet on a downtrend

By Emma Trincal

New York, Feb. 14 – Royal Bank of Canada’s $1 million of 0% bearish barrier digital notes due Nov. 9, 2023 linked to the S&P 500 index may be used as a directional bearish bet or as a hedge depending on investors’ viewpoints, advisers said. Investors considering the notes should expect volatility to be contained during this short-dated investment as any large move on the upside or on the downside would either create losses or cap the gains.

If the index return is zero or negative, the payout at maturity will be par plus 17%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is positive but less than or equal to 15%, the payout will be par.

If the index return is greater than 15%, investors will lose 1% for every 1% that the index gains.

Rates-related

“This is a note for someone who is convinced that rates will continue to rise nine months from now. The fact that it priced last week ahead of CPI is not a coincidence,” said Tom Balcom, founder of 1650 Wealth Management.

The Labor Department on Tuesday reported an increase in January’s Consumer Price Index, up 6.4% year over year. While the number was much lower than the 9.1% peak in June, it was still higher than analysts’ expectations.

“The 17% return in nine months if the market is negative or even flat is very attractive. If your view is that the Fed is nowhere near cutting rates, then you’ll be able to monetize this viewpoint,” he said.

“You could use the notes if you’re bearish. An acceleration of the war in Ukraine, tensions or economic sanctions with China could definitely affect the S&P.

“But to me this trade is more of a hedge, something that you may use in a small portion of your portfolio.”

Rate cuts or any economic improvement could spur a rally, putting investors at risk if the index rises more than 15%, he said. But if the note is used as a small hedge, any losses would be offset by the long positions in the portfolio.

A difficult talk

Despite those benefits, Balcom said he would be hesitant to use the notes.

“I think it depends on your conviction. Right now, it’s difficult to forecast the market. There are too many things going on from the Fed to China and Ukraine,” he said.

Sometimes the adviser’s practice is as much at risk as the client, he added.

“I don’t really like betting against the market. If the market is up 20%, this note will make you lose 20%. If that happens, you get a call from the client asking you: why did I underperform by 40%? It’s a really tough conversation to have,” he said.

Bearish bets may not yield the expected result and carry too much reputational risk, he added.

“Two thirds of the time, the market is up,” he said.

The nature of the downside protection could have made a difference, he said.

“If I had a 15% buffer, it would change everything. Market is up 20%, I’m down 5%. That’s a much better place to be than market is up 20%, I’m down 20%.”

Favorable odds

A financial adviser said he could see the notes used as a moderately bearish play.

“I like it because I think the chances for the S&P to be higher in nine months are really low,” he said.

The 17% digital return represented a cap on the gains, which true bears may not appreciate, he noted.

“But if you’re really bearish, you should short the S&P, not buy that note. For someone who isn’t sure however, the note offers a relatively high probability of earning 17% at maturity,” he said.

The note could be used as a complement to a short trade.

“It’s something you could do separately,” he said.

This adviser expects the market to drop substantially.

“I think the S&P will go down more than 17% just because it’s trading more than double its fair value,” he said.

The S&P 500 index is trading at approximately 4,140.

“Also, people are extremely complacent right now. They’re back into buying risky assets, piling on call options. Confidence is rising. The VIX recently hit a one-year low. All those things are red flags,” he said.

This adviser expects the index to drop more than 35%.

“Even if it bounces back and it will, it’s not going back to its current level...Not in nine months,” he said.

Since the intensity and speed of a recovery is unknown, the notes offer a “decent payout” in a bear market.

“It gives you a very good chance of making 17% in less than a year. So, I think it’s a reasonably good investment in this market,” he said.

RBC Capital Markets, LLC is the underwriter.

The notes settled on Friday.

The Cusip number is 78016HRX0.

The fee is 0.5%.

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