RBC’s $3.82 million buffered leveraged notes on Russell offer recovery bet on laggard

By Emma Trincal

New York, Dec. 15 – Royal Bank of Canada’s $3.82 million of 0% buffered enhanced return notes due June 12, 2025 linked to the Russell 2000 index allow investors to participate in the possible rebound of an underperforming index, said Clemens Kownatzki, finance professor at Pepperdine University.

If the index return is positive, the payout at maturity will be par plus 200% of the return, capped at par plus 23.9%, according to a 424B2 filing with the Securities and Exchange Commission.

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

Laggard

“In the last decade, the Russell has been underperforming the other major benchmarks quite a lot,” said Kownatzki.

In the last 10 years, the compounded annual return of the Nasdaq was 17.8% and 12.1% for the S&P 500, but only 7% for the Russell 2000, he noted.

On a year-to-date basis, the Nasdaq is up more than 40% while the Russell has gained 13.4%. Meanwhile the S&P 500 index posted a 23% increase.

The Russell 2000 has scored a strong performance over the past few days, he noted.

After the Fed meeting on Wednesday and through Thursday midday session, the small-cap benchmark jumped 5%.

Tech momentum

“Large-cap have outperformed small caps because investors are fixated on a few big names with extreme valuations, which are driving most of the returns in the equity market,” he said.

“The so-called “Magnificent Seven” captured so much weight in the indexes, they pushed the return much higher.”

Small-caps historically have done well, he said, but on a relative basis, their track record is disappointing compared to growth stocks.

High interest rates

Since the Federal Reserve began raising short-term interest rates nearly two years ago, the disparity of returns has increased, he said.

“The additional 500 basis points in interest rates has been a drag on the performance of small-cap stocks.”

On a relative basis, small-caps are getting hurt more than large-caps in a high interest rate environment, he noted.

“Big companies have more avenues available to finance themselves. They have more sophisticated tools to manage interest rate risk.”

Higher interest rates have a negative impact on the earnings of tech companies because future cash flows are discounted at higher rates. But the growth of those businesses more than offset the valuation issue.

“The burden of high interest rates is greater for small-caps because those companies are much more dependent on financing than larger companies,” he said.

Divergence of returns

The main factor behind the outperformance of large-cap stocks has been investors’ fascination with technology, he said.

“For the last 10 years, the attention of investors has been centered around big, high-growth corporations rather than small, traditional companies,” he said.

The significant disparity of returns between the Nasdaq and S&P 500 on the one hand and the Russell 2000 makes the notes timely, because the entry point is favorable, he said.

The Russell 2000 index closed at 1,868 when the notes priced on Dec. 7, or 24% off its all-time high of November 2021.

In comparison, the S&P 500 index on Thursday scored a one-year high, which was only 1.8% off its all-time high of January 2022.

“Clearly there is room for the Russell to catch up.”

During its meeting on Wednesday, the Federal Reserve did not cut interest rates but implied that cuts may be coming in 2024.

“Small-caps should do much better when rates come down. If they get lower financing costs, they will catch up with the other benchmarks.”

Limitation

Kownatzki then pointed to one negative aspect of the structure.

“It’s a good way to play the reversion to the mean,” he said.

“But I’m afraid you may hit the cap too quickly.

“The risk here is on the upside.

With two times leverage, the 23.9% cap over the 18-month tenor represents a maximum return of 15.4% per annum on a compounded basis. Such gain only requires a 7.8% annual growth in the index.

“It’s absolutely possible to hit that cap.

“In a soft-landing scenario, with a stronger economy, lower interest rates would give smaller companies a real boost.

“You have to weigh in the Election year of course and the political tensions that are likely to come up.

“But overall, I’m less concerned about the downside risk. You have a 10% buffer, and we’re still well below the previous high.

“I expect a rebound in the small-cap space. But you may be missing a significant amount of the return.”

RBC Capital Markets, LLC is the agent.

The notes settled on Dec. 12.

The Cusip number is 78017F2P7.

The fee is 0%.

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