RBS' enhanced participation notes linked to S&P 500 offer chance to outperform the benchmark

By Emma Trincal

New York, March 30 - Royal Bank of Scotland plc's 0% enhanced participation notes due April 9, 2015 linked to the S&P 500 index offer an attractive alternative to a direct investment in the benchmark with the potential to outperform the market, said Suzi Hampson, structured products analyst at Future Value Consultants.

"Apart from [not] receiving the dividends and taking on the credit risk, you'll always outperform the index with this product since you have some form of downside protection and no limitation on the upside," she said.

The payout at maturity will be par plus 1.2 to 1.25 times any index gain, with the exact participation rate to be set at pricing, according a 424B5 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 10% and will lose 1% for every 1% that it declines beyond 10%.

"This note is designed for bullish investors. In a modest growth scenario, the little bit of leverage helps enhance returns. And the more aggressively bullish investors are not penalized with a cap. Overall, this is something that performs best when the index grows as much as possible," she said.

Mostly credit risk

The 10% buffer makes the product less risky than average, she said, based on the notes' riskmap.

Riskmap is Future Value Consultants' rating that measures the risk associated with a product on a scale of zero to 10. The higher the riskmap, the higher the risk of the product.

The notes have a 4.73 riskmap versus an average 4.57 riskmap for all products and therefore present more risk.

"The market risk is relatively low here. What raises the riskmap is the credit risk," said Hampson.

Future Value Consultants breaks down its riskmap score into a market riskmap and a credit riskmap. The riskmap is the sum of those two components.

The market riskmap for this product is 3.05, less than the 3.81 average score for similar products - or other leveraged notes - and less than all products, which have a 3.90 average score.

Several factors explain the lower market risk level of these notes, including the fact that many of the other products recently rated are reverse convertibles, which are linked to more volatile underlying such as stocks. Also, many products offer less attractive protection features than a buffer, such as barriers. Even when a buffer is provided, downside leverage may be added to reduce the protection on the downside beyond the buffer.

"You have a 10% buffer. Although it's not much, it's better than a barrier or nothing. The underlying is less volatile than stocks or other benchmarks," she said.

The 1.67 credit riskmap, on the other hand, is higher than average when compared to the average of all products (0.67) and the average of similar products (0.88).

For one thing, the three-year tenor is longer than the average note. The longer the duration, the greater the exposure to credit risk for the investor, she said.

In addition, RBS has five-year credit default swap spreads wider than other U.K.-based banks, she noted.

Five-year CDS spreads for RBS are 280 basis points. In comparison, Barclays is under 200 bps and HSBC is under 135 bps, she said.

"You have a combination of credit risk of the issuer and duration of the product," she said.

High return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

"With this uncapped product, the most favorable market environment is high growth. It's under this assumption that we've scored the return and estimated the probabilities of return," she said.

The strength of the product, she said, is its high return score of 8.05 on the zero to 10 scale. The rating compares favorably with 7.09, the average return score for the same product type. The average return score for all products is only 6.45.

"In a high-growth scenario, having a buffer on the downside as well as no cap on the upside with some leverage is going to give you an appealing risk/reward profile," she said.

"You will outperform the underlying index if the market goes down as you have this 10% buffer.

"And the 1.2 to 1.25 gearing will enhance your gains. You still lose on the dividends, so maybe the leverage compensates you for that. But your risk/return profile is still very attractive."

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the five key assumptions. It assigns a probability of return outcome to each of the payoff buckets.

The chart is generated using a Monte Carlo simulation using various parameters such as volatility, dividends and interest rates.

Based on the high-growth assumption, there is an 82% chance that the product will generate a positive return. In this right part of the table, the probability of an annualized return of 15% or more is 28.6%.

Separately, the odds of a negative return are 18%. In this left part of the chart, the worst scenario - a loss of more than 15% per annum - represents a probability of 7.8%.

Those probabilities change under a neutral assumption, which is a risk-free growth scenario.

The cash scenario shows a 62% probability of generating a positive return and a 38% chance of incurring a loss.

Price, overall

A less attractive part of the product is its pricing, said Hampson.

Future Value Consultants uses its price score to measure on a scale of zero to 10 the market value of the underlying components of the product as a percentage of the initial investment. The score gives an estimate of the fees taken per annum.

The higher the score, the lower the fees and the greater value offered to the investor.

The price score for these notes is 6.56, compared with 7.35 for similar products.

"It's not brilliant," she said,

"It could be because of the credit risk. The potential return should increase with the level of credit risk, and perhaps investors are not getting from the options the value they should get in order to be adequately compensated for that risk."

This assumption does not diminish the foundation of the return score, she noted.

"The return score is more risk/return associated. You can still score high on the return scale but not necessarily benefit from the best value."

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

At 7.30, the overall score is better than that of all products (6.70) and slightly more than comparable structures, which score 7.22 on average.

"This reflects the very good risk/reward profile with the not so good price score. Overall though, this note scores very well," she said.

The notes will price on Tuesday and settle on April 9.

RBS Securities Inc. is the agent.

The Cusip number is 78009PCR0.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.