RBC's absolute return barrier notes due 2014 tied to S&P 500 are aimed at bulls, hedgers

By Emma Trincal

New York, Oct. 12 - Royal Bank of Canada's 0% absolute return barrier notes due April 29, 2014 linked to the S&P 500 index are mostly designed for bulls given the uncapped upside. Despite the absolute return feature, which may also appeal to neutral or indecisive investors, the product is foremost a growth product, said Suzi Hampson, structured products analyst at Future Value Consultants.

With absolute return products, which Future Value Consultants categorizes as "straddles" or "multi-directional" products, investors are poised to capture gains out of a rising or declining index as long as the price move on the downside does not breach a preset barrier.

The payout at maturity will be par plus any gain in the index, according to an FWP filing with the Securities and Exchange Commission.

If the final index falls below the initial level but remains above the barrier level during the life of the notes, the payout will be par plus the absolute value of the return. The exact barrier level, expected to be between 77.5% and 81.5%, will be set at pricing.

Otherwise, investors will be fully exposed to any losses.

Barrier and risk

The barrier used in the notes is monitored during the term and not just at maturity, noted Hampson, adding that this point had significant consequences.

"This type of barrier increases the chances of losses and therefore is more risky than a final day barrier," she said.

A lot of other absolute return products have payout terms that provide for a final day barrier rather than a daily observation seen with this product, she said.

With those deals, what determines the payout is the final level of the underlying, she said.

"The barrier monitored during the term makes losing capital much more likely," she said.

But while the type of barrier employed in this note increases the risk, some other aspects of the structure offset this negative characteristic, she added.

The first one is the amount of contingent protection, which goes from 18.5% to 22.5%.

"We're talking roughly 20%. This is a good protection level. It's more than a lot of the products we see in the U.S."

Another factor which reduces the risk is the type of underlying being used, she noted.

"Other straddle-types of products are tied to reference assets that are more volatile than the S&P 500, like stocks or other funds or indexes," she said.

As an example, she cited the MSC EAFE index fund, the MSCI Emerging Markets fund, the Russell 2000 or stocks like Apple Inc.

With those advantages combined, the notes overall ended up with a lower riskmap than the average of the same types of products.

The riskmap is a Future Value Consultants' rating that measures the risk associated with the product on a scale of 0 to 10. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

With a 3.45 riskmap, the notes compared better than the average riskmap for other straddles at 4.04. They were even less risky than the 4.10 average observed for all products.

The market riskmap, in particular, at 2.81, was lower than the score observed for straddles at 3.30.

"The lower riskmap of this product compared to its peers may have to do with the fact that other products may have a higher barrier, for instance 90% instead of 80%, and perhaps a not-so-good barrier over a longer period of time. This is an 18 month, which is in the shorter end of the range. You would expect more risk on a three-year product," she said.

Bullish product

Another positive aspect of the structure is the uncapped upside, she said.

The notes give investors a one-for-one appreciation in the index with no limit to the upside.

"You usually find a cap with these straddles or multi-directional products. This one doesn't have one. It's a plus.

"You can compare the upside of this with a tracker or a growth product and you also have the benefit of the downside protection," she said.

Absolute return notes are sometimes marketed as neutral plays. The directionless products may appeal to mildly bullish or mildly bearish investors who do not expect wide price moves.

But Hampson said that the structure was not ideal for mildly bearish or neutral investors.

"You really want the market to go up. This product is really aimed at bullish investors," she said.

"In theory, you could argue that it may appeal to uncertain investors, people who do not have a particular view, those would bet the market will go up but with no conviction, happy to be able to cover their back. It could even appeal to bears, at least in theory.

"But you really have to consider the risk of getting too close to the barrier level. The closer you get to it, the harder the losses. As an investment, it's more relevant as a bullish bet.

"This one is even more bullish than most equivalent products because nothing limits your upside.

"If you were not bullish you would go with a cap and choose leverage.

"It's kind of a mixed product. Yes you can say that you can make money either way but you don't really want to pursue gains on the negative side. It's too risky. I think it's more of a selling point to be able to say that you're going to make money when the index is down. But it would be sort of misleading. This is not what the notes are designed for," she said.

The notes are well suited for two strategies: a bullish bet or a hedge.

"If you're already long the market and need to protect yourself from a selloff, when there is a selloff, this can take some of the pain out," she said.

Return and price

Future Value's opinion of the risk-adjusted return is measured by the return score. The return score is calculated from five key assumptions - neutral assumption, high and low growth environments, and high and low volatility environments. FVC calculates a risk-adjusted average return for each assumption. The score is the best of these five returns.

This product has a 7.69 return score, which exceeds the average return score of its peers at 7.42. The return score is also greater than the average of all products, at 6.57.

"Not having a cap is the key here. The risk is already lower than other products and your upside potential is unlimited," she said.

"Other products score lower because they may have more volatile underlying and for the most part they have a cap."

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the five key assumptions. The chart is generated using a Monte Carlo simulation using various parameters, such as volatility, dividends and interest rates.

The probability table associated with this product under a neutral scenario (or risk-free growth) shows that investors have a probability of losing versus winning of one-third and two-third, respectively.

Since the return score is calculated based on the best among the five return scenarios, the probabilities would have to reflect the best assumption, which in this case would be: high growth.

In a market environment characterized by high growth, the odds of losing capital fall to 18% while the probabilities of generating a positive gains rise to 82%.

Future Value measures a note's worth on a scale of zero to 10 with its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes received a 7.74 price score, which is less than the average of same product type at 8.10.

"It's still high and it's nothing to worry about. Straddles represent a small product type compared to other categories like reverse convertibles. It could be one particular product with a high score that could have pulled the average. The fewer products you have in any given category, the harder it is to compare pricing," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents the firm's opinion on the quality of a deal. These notes have a 7.71 overall score compared to 7.76 for similar structures and 6.81 for all products.

"It scored quite well. It's higher on the return scale and the price score is slightly lower, but it's not really worrying given the category. You have good value on average with potentially less risk and a high return potential," she said.

The notes (Cusip: 78008SNE2) will price on Oct. 24 and settle on Oct. 29.

RBC Capital Markets, LLC is the agent.

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