RBC’s buffered bullish leveraged notes linked to Dow are appealing on both ends, sources say

By Emma Trincal

New York, Sept. 8 – Royal Bank of Canada’s 0% buffered bullish enhanced return notes due Sept. 30, 2019 linked to the Dow Jones industrial average offer enough of a cap and a buffer to be attractive for most bullish investors, sources said.

The payout at maturity will be par plus 115% of any index gain, up to a maximum return of 57% to 62%. The exact cap will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 20% and will lose 1% for every 1% decline beyond 20%.

Conservative structure

Carl Kunhardt, wealth adviser at Quest Capital Management, said he likes the downside structure, noting that the notes offer a good defensive play through the combination of a five-year maturity and a 20% buffer.

The cap and the five-year tenor used to finance the buffer do not represent major drawbacks in his view.

“If you’re going to have a buffer, you have to pay for it, so of course the notes are going to be capped,” he said.

“Regarding the length, I don’t see five years as long-term anymore, at least for buffered notes. You rarely see 18-month notes. The shorter we can find is three years. Four or five years is becoming kind of the norm.

“And from a credit risk standpoint, you’re not going to get much better credit than RBC.”

Based on historical charts of the Dow, Kunhardt explained that the five-year tenor adds a level of safety to the structure compared to a shorter-dated product.

“If you combine the 20% buffer and the historical performance of the Dow on any five-year stretch, I see little risk of losing money,” he said.

“Your worst scenario would be if the note was to mature into a market correction. Based on historical charts, there have been very few five-year periods of negative return. With the 20% buffer, there is little chance of losing principal as a result of a correction.”

Tail risk: 1929

Kunhardt said the Great Depression was an exceptional case. He attributed the length and severity of the crisis to errors made by the administration at the time as it implemented the wrong economic policies. A similar scenario would be unlikely to happen today because the Federal Reserve has taken important steps in the most recent crisis to inject liquidity into the system in order to avoid another panic and prevent a systemic crisis.

“Even if you take the Great Depression, which wiped out portfolios over a long stretch of time, you’re talking about two market corrections, not just one,” he said.

“You had the 1929 crash first, but it was followed by a second correction in 1932, which was caused by poor economic conditions and bad decisions. Black Thursday was just the result of a lack of check and balance in the system. It was margin calls gone mad. By 1931, the market had fully recovered from the bottom of the 1929 crash, but the policies put in place then precipitated a second crash.”

The Great Depression – a situation characterized by two consecutive crashes – is a very exceptional situation, he said.

“In such scenario, the only [thing] that’s going to protect you is if you don’t play the game at all,” he said.

More realistic scenarios

A more realistic approach would be to study the last two major market corrections, he said, pointing to the financial crisis of 2008 and the dot-com bubble of 2000 less than a decade before.

“You have a first-case scenario with a severe, short-lived crash like 2008 when the market lost nearly 40%, but it only lasted six months. The other extreme is the long crash of 2000, which only ended in 2003 but was much milder in intensity,” he said.

Rarely did the Dow show a devastating crash extended over a long period of time, he explained.

“Of course the Great Depression is the exception, but again, the length and severity of the crisis was caused by a series of bad political decisions,” he said.

“We can always come up with all sorts of catastrophic scenarios, but realistically, the chances of a major crash over the five-year term seem slim in my opinion.”

In addition to the five-year tenor, the downside protection makes the product very defensive, he said.

“The buffer is key. A 20% hard buffer reduces the risk significantly,” he said.

“Suppose the market is down 35%. You need to be up approximately 50% to be back to even. But you have the 20% buffer, so you really have to be down 70% to lose money. That’s huge. It would take a lot to finish in the red.”

Kunhardt said he likes buffered notes because they offer something long-only positions lack.

“I like this deal very much. There’s really nothing not to like,” he said.

Good upside

Jim Delaney, head trader at Market Strategies Management, is more interested in the upside. He said that the cap offers investors enough potential return, especially if the market turns flat or volatile, with bad years offsetting part of the positive gains seen in other years.

“The buffer is not what interests me the most here. Buffers obviously have value. But if you’re down 20% in five years, obviously you have much bigger problems,” Delaney said.

“Right now the Dow is at 17,129. If the Dow was down from today by 20% in five years, it would mean that it’s at 13,700. I don’t see that happening. Therefore, I don’t see that buffer coming into play.

“Now let’s go to the other side,” he said, in reference to the upside.

With a hypothetical cap of 60%, investors would have a 9.85% annualized cap with compounding. By applying the 1.15 leverage factor, the index would have to grow by 8.75% a year on a compounded basis, he said.

“That gives the index enough room over five years,” he said.

“The Dow is up about 3.30% this year. The S&P has gained a little bit more, but it’s still in the single-digit at about 8%.

“But let’s just focus on the Dow since it’s the underlying index of the notes. Say you have that kind of growth for another couple of years, then over the five-year period, the leverage is going to help and the cap is not going to hurt you. The way the Dow is going, you wouldn’t bump into the cap.”

Cap hard to hit

Delaney assumed an uneven market over the next five years with down years and up years.

“As soon as you miss that cap by 5%, even if you have a double-digit growth, it gives you room,” he said.

“Say we’re up only 3.75% this year for the Dow. Your index cap is 8.75%. You missed 5%. Even if you have [a] double-digit return next year, for instance you have 12%, the leverage will help you catch up with what you missed in the early years.

“So the cap is well priced. If the market was up 8.75% a year for the next five years, that would make a lot of people very happy. It’s not a bad cap at all. You can be pretty bullish and still like the notes. You just can’t be extremely bullish.

“If I had to redo the structure my way, I would probably cut the buffer in half to 10% and raise the cap in order to get 11% to 12% a year.”

RBC Capital Markets, LLC is the agent.

The notes will price Sept. 26 and settle Sept. 30.

The Cusip number is 78010UY84.

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