RBC’s leveraged notes linked to Energy Select fund offer attractive cap, but risk is high

By Emma Trincal

New York, Jan. 23 – Royal Bank of Canada’s 0% bullish enhanced return notes due Jan. 26, 2017 linked to the Energy Select Sector SPDR fund are designed for aggressively bullish investors who are betting that energy prices will recover two years from now, said Tim Vile, structured products analyst with Future Value Consultants.

The payout at maturity will be par plus 200% of any fund gain, subject to a maximum return of 34% to 38% that will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will be fully exposed to any decline in the fund.

Vile said that he used the mid-point of 36% as the hypothetical cap to rate the notes. In each research report, Future Value Consultants assesses risk, return and price using a variety of proprietary scores in order to compare a product to its peers. In this case, peer products are leveraged notes of varying durations that may or may not have a cap or downside protection.

Volatility

“The underlying fund is an equity fund of energy stocks, and as such, its performance [is] very correlated to oil prices,” Vile said.

“Given the current drop in oil prices, this fund is more volatile than the S&P. It has a one-year implied volatility of 26% versus 21% for the benchmark.”

Despite the diversification of the fund, its focus on energy stocks increased its volatility, he noted.

The top three holdings of the ETF are Exxon Mobil Corp. (16.63%), Chevron Corp. (13.63%) and Schlumberger NV (7.22%).

With two-times upside exposure and a 36% cap, investors may expect up to 16.60% annualized return with compounding. In order to reach this cap, the fund needs to gain 8.65% a year, or 18% during the two-year term, he said.

No protection

“The upside is the main feature of the notes. The downside offers no particular benefit compared to the fund as you’re long the fund on the downside just as you would be as an equity investor,” he said.

“However, one positive side of the notes is that you only have a one-to-one downside exposure. That’s a great advantage versus a geared exposure to the fund.”

Still, when compared to similar products, the notes presented a high risk profile.

“Unlike many leveraged notes, this product has no barrier and no buffer. Investors must have a strong faith in their bullish bet, otherwise there is no point,” he said.

“This note reflects the idea that oil has already dropped a lot and that within two years, energy stocks should rebound.”

In the last six months, the fund has lost 22%.

“Whether the sector will recover and whether it will happen in two years, no one knows. So this is quite a risky bet,” he said.

Riskmap

Future Value Consultants assesses the risk associated with a product by adding two risk components: market risk and credit risk. The resulting riskmap measures risk on a scale of zero to 10 with 10 as the highest level of risk possible.

The market riskmap for the product is 5.61, compared with an average 3.39 market riskmap for the product type, according to Future Value Consultants’ report.

“It’s due to the fact that many leveraged notes are tied to the S&P 500 index or to broader indexes. This fund tracks the performance of a sector, and this happens to be a sector that’s in bear market territory,” he said.

“Another reason is the absence of any defensive features in the structure. Buffers or barriers are very common with leveraged notes, but you don’t have any of that here. As a result, the market risk is relatively high.”

The credit risk, on the other hand, at 0.44 was lower than the average for this category of 0.54.

Vile attributed this result to the creditworthiness of the issuer, which is rated AA- by Standard & Poor’s.

Risk versus reward

Future Value Consultants measures the risk-adjusted return of a product with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets, and high- and low-volatility environments. The score for the RBC product is calculated on the basis of the bullish scenario.

At 7.04, the return score is below the 7.70 average for this type of product, according to the report.

“A 16% annual return looks attractive at first glance. But you’re still capped,” he said.

Compared to longer-dated and uncapped leveraged notes, the product had less room to grow, he explained.

“It’s a nice return, but you are incurring full downside risk,” he said.

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. 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 price score is “weak” at 6.36 versus an average of 7.36 for the same product type, he said.

“Part of it is the short term. When we calculate the price score, we take into account the price of the assets and the duration. Since we calculate the fees per annum, a shorter duration will not reflect well on the score,” he said.

“The low price score also suggests that the issuer did not spend enough money on the options. A higher cap or a barrier would have increased the price score.”

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The notes showed a 6.70 overall score, compared with a 7.53 average score for the leveraged notes category.

“This product is designed for bullish investors who want to capture an attractive return. But the score tells us that risk is quite high for the return you’re getting, something investors may want to look into,” he said.

The notes (Cusip: 78012KAW7) were scheduled to price Friday and will settle Wednesday.

RBC Capital Markets, LLC is the agent.

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