RBC’s PLUS tied to three indexes, three ETFs feature unusually short tenor on leveraged note

By Emma Trincal

New York, June 20 – Royal Bank of Canada’s 0% Performance Leveraged Upside Securities due Jan. 3, 2019 linked to a basket made up of three indexes and three exchange-traded funds present an unusually short tenor for a leveraged note.

The underlying basket was also noteworthy.

It includes the Russell 3000 Value index with a 25% weight and the Euro Stoxx 50 index, the Euro Stoxx Banks index, the VanEck Vectors Gold Miners exchange-traded fund, the Consumer Staples Select Sector SPDR fund and the iShares U.S. Telecommunications exchange-traded fund, all with a 15% weight.

The payout at maturity will be par of $10 plus 200% of any index gain, subject to a maximum payment of $10.58 per PLUS, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be fully exposed to any index decline.

Dividends

“The first question is why this basket? Why these weightings?” said Alexandre Péroux, president of Fin Avenue.

“It’s always good to be diversified. But when you put together a strategy index, a broad index, a sector index and three sector ETFs it’s a bit weird. At some point, you have to justify the choice. There might be a story behind it.”

He noted the inclusion of the Euro Stoxx Banks index along with the broader Euro Stoxx 50, which already allocates 20% to financials.

“There is some overlap for sure,” he said.

Some of the basket components are high-yielding assets, he noted.

“The high dividends will give you low forwards. It means from a pricing perspective; the options will be cheaper.

“It’s the way to enhance the structure.

Some of the basket components indeed pay high dividends. The iShares U.S. Telecommunications ETF has a dividend yield of 3.58%. The Euro Stoxx 50 index has a 3.20% yield. The consumer staples fund yields 2.85%.

This benefit of the cheaper forwards is naturally limited by the very short duration, he added.

“If you could use the same dividend yields over five years, the forwards would be crazy low,” he said.

Six-month term

Perhaps more unusual even was the use of leverage on a six-month note.

“There is no downside protection and it’s very short. It may be riskier from a certain point of view, definitely,” he said.

One way to attenuate the risk was to develop an investment discipline similar to “dollar cost averaging,” he said.

“If you strike these deals on a regular basis, each month for instance, you build a number of entry points that will mitigate the risk that comes with market timing.”

Some advisers argue that highly diversified underliers help mitigate market risk as well.

“It’s always good to be diversified. But the individual bets you’re taking have to make sense. Those are very specific bets. I’m sure they make sense.

“But it’s hard to make a judgment on a deal without knowing the underlying strategy,” he said.

Correlation

Jason Barsema, co-founder of Halo Investing, was also intrigued by the basket.

“It’s unusual. I suppose he or she may want exposure to these specific sectors or markets. They had to have a special thesis behind the trade,” he said.

At first glance, diversification is often an advantage. His concern however was that in a down market, those basket components may prove to be more correlated than they appear to be.

“The gold may give you some diversification. But retail, telecom and all cap value...if the market gets killed on the downside, the correlations will go to one,” he said.

“Back in February when we had the interest rate scare, the volatility scare, the market as a whole pulled back. Small-caps were protected a little bit but most assets dropped. That would be one of my concerns.”

Tradeoff

Barsema also pointed to the dividends.

“When I am sacrificing the dividends, I either get some really good leverage on the up or some protection on the down.

“Here my maximum gain is 12% a year. The index is up 6% a year and I’m capped out.”

Also at issue was the tax treatment of a less than one-year leveraged note.

“I’m taxed at a higher rate on short-term capital gains. I sort of have to realize these gains, while if I own the funds outright, I don’t have to sell. I own the ETFs. I can wait another six months plus one day.

“I’m not saying it’s a bad product. You can’t really tell until you know what’s the rationale behind the structure. But it’s probably not for us.”

RBC Capital Markets, LLC is the agent with Morgan Stanley Wealth Management handling distribution.

The notes will price on June 29 and settle on July 5.

The Cusip number is 78014G203.

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