RBC’s $1.3 million bearish digitals on S&P show eye-catching return, full exposure to losses

By Emma Trincal

New York., Feb. 14 – Royal Bank of Canada’s $1.3 million of 0% bearish digital notes due Feb. 13, 2025 linked to the S&P 500 index should appeal to bears as the note delivers an unusually high digital payout in a declining market. But bearish convictions need to be strong given the absence of any protection should the bet turn out to be the wrong one.

If the index finishes at or below its 95% digital strike level, the payout at maturity will be par plus 46.85%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes at or below its initial price but above 95%, the payout will be par.

If the index finishes above its initial price, investors will lose 1% for every 1% that the index increases.

“I’ve never seen something like this,” said Brady Beals, director, sales and product origination at Luma Financial Technologies, about the size of the digital payout.

Digital

The structure was a good fit for a bearish bet.

“I think it’s really smart to do a digital if you’re going to express a bearish view. Usually, bearish notes are based on a one-to-one participation. If the market is flat or only slightly down, you may not have a great return.

“This one gives you 47% in one year regardless of how much the index drops as long as it drops at least 5%. It’s a great hedge.”

Volatility, interest rates

The high payout required specific pricing conditions even if suppressing the “downside” protection helped cut the cost of structuring the note.

“For one thing, volatility is much lower, so options are cheaper,” he said.

Rising interest rates also contributed to stretching the digital return.

“With higher rates you would expect the S&P futures curve to be relatively steep,” he said.

A simplified formula for futures prices would be the spot price multiplied by the difference between interest rates and dividends. As a result, futures prices will increase with higher interest rates and lower dividends.

With the dividend yield of the S&P 500 trending downward and interest rates on the rise again, futures prices have increased, he explained.

“Futures are high, which means that the model will price an increase in the value of the S&P 500,” he said.

“Pricing models are purely academic. They don’t take into account market sentiment. They don’t incorporate the notion that markets may be overvalued. It’s just a formula.”

But the formula determines the cost of packaging the options.

If the model implies a rise in the S&P 500 index for the period, the cost of structuring a bearish note will be cheaper, he explained.

The unprotected structure, however, was not for everyone.

“People will use this note to express a contrarian view. It’s a tactical approach based on a high level of conviction since there is no protection, and therefore no room for error,” he said.

A trader said the risk was too high.

“It’s not a good deal because 100% of your investment is at risk,” said Mark Dueholm, chief fixed-income trader at Landolt Securities.

“The risk of losing money is extremely high. If the market is up 100%, you lose your entire investment. I think there is a strong chance for the market to be up a year from now. Bears don’t believe it. They anticipate a crash. But they were saying that last year too and the market ended up being surprisingly strong.

“Doing anything without some level of protection is not attractive to me.”

Cheap puts

Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments, who is bearish on U.S. equities, was upbeat about the note.

“It’s a good gamble if you want to call it a gamble,” he said.

“There is no protection if the index is up, but I don’t see a whole lot of risk in being bearish right now,” he said.

He pointed to the S&P 500 index surpassing 5,000 and scoring successive all-time highs.

In addition, many of the S&P components are companies showing prices surpassing their profit and trading as much as double their fair value, he said.

“They can give investors 46.85% by getting rid of the protection. But I think they’re mostly taking advantage of the fact that put options are at an all-time low. Their volume has dropped relative to call volume. People are so bullish they’re buying calls and they’re not buying protective puts. The volatility has collapsed making puts much cheaper. And since we’re talking about European put options, you get a whole year for that trade,” he said.

Low put prices were a sign of complacency, which should raise a red flag, he added.

An at-the-money put with a Feb. 21, 2025 expiration (similar to the maturity date) was showing an implied volatility of 17 on Wednesday.

“That’s pretty low. The implied vol. for SPX puts tends to be closer to 25,” he said.

While there is no guarantee that the digital bearish play will be profitable, Kaplan pointed to other bearish signals, such as record high insiders’ selling and a high percentage of stocks held by individuals – 50% versus 28% to 29% on average. Moreover, the put/call ratio hit its lowest point since 2020.

“The chances of the S&P finishing down more than 5% in a year are very high,” he said.

“It’s really a good note.”

RBC Capital Markets, LLC is the underwriter.

The notes settled on Tuesday.

The Cusip number is 78017FFQ1.

The fee is 2%.

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