RBC's absolute return notes linked to S&P 500 would benefit from volatility staying in check

By Emma Trincal

New York, July 26 - Royal Bank of Canada's 0% absolute return barrier notes due Jan. 29, 2015 linked to the S&P 500 index are designed for investors who do not anticipate big swings in the market two-and-a-half years from now, sources said. Instead, they are expecting the index to stay within a range.

If the index finishes at or above the initial level, the payout at maturity will be par plus the index return, subject to a maximum return of 25.75% to 28.75%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes below the initial level but above the barrier level, 71.25% to 74.25% of the initial level, the payout will be par plus the absolute value of the index return. The exact barrier level will be set at pricing.

Otherwise, investors will be fully exposed to any losses.

"They're taking a straddle and replicating it into a structured note," a market participant said.

Straddle

The trade is called a short straddle, an options trader said. It involves writing a call and a put at the same strike price and expiration.

To simplify his explanation and based on the ranges announced in the prospectus, this options trader picked two hypothetical strikes for an initial price of 100, one at 75 for the short put position and the other at 125 for the short call.

The risk for this type of trade, he noted, is that at maturity, the benchmark will close outside the expected trading range. With this product, investors will see their return capped up to a hypothetical and rounded up 125 strike on the upside, allowing up to 25% in gains from a price appreciation. The downside is also capped at 25.

Wide range

"You make money if the S&P finishes down but above the 75 strike. And you make money if it stays below the 125 strike on the upside. You have a 50-point range where you can make money," the options trader said.

"Above 25 from the initial price, you're only making a certain amount. And below 75, you can lose your entire investment.

"The 75 put is not a pure put. It's an out once you hit the strike, the put is out."

In effect, once the 75 barrier is breached, investors incur losses from the initial price of 100, not from 75.

"I'm not too sure how they get to that and how they get the absolute return. It's probably not with listed options," he added.

"But I don't think it's a bad bet. Think of how many stocks that can go to zero. With this, you have a 50-point range where you can make money. And you have two-and-a-half years to settle in the range."

Volatility play, duration

Given that the strategy can fail if the implied volatility increases at maturity, some saw in the trade essentially a volatility bet.

The longer the timeframe, the harder it is to predict what the market moves will be like, they noted.

According to the prospectus, investors can participate in the upside up to 25.75% to 28.75%, which represents an annualized cap in the 10.3% to 11.5% range.

"Nobody is going to complain about those rates or return. You would only mind if you go above that," said Steve Doucette, financial adviser at Proctor Financial.

"I do like the absolute return component. Just imagine the S&P 500 drops 22%. You're outperforming the market by 44%.

"The flip side is it's [almost] three years out. That's the tough call. Look at how the market reacted to news today. The ECB says they won't let the euro fail and the Dow is up almost 1.7%.

"Who knows what volatility will be like in 2015. Mr. Market has a mind of its own. To me, duration is the issue here."

However, Doucette said he likes the credit risk of the issuer.

"RBC is at the top of the list," he said.

Election wildcard

The market participant was more concerned with the timing of the trade ahead of the U.S. elections than its length in time.

"This note matures well beyond the horizon I'm looking at now. To me, that's the challenge.

"After the elections, it would be easier to take a view. A lot can happen after that.

"Take the Bush tax cuts. If the taxation of dividends and capital gains will be treated differently, investors will think differently about investing in the S&P.

"You have a lot of uncertainty from now until November," he said.

The notes (Cusip: 78008SEQ5) are expected to price Friday and settle Tuesday.

RBC Capital Markets, LLC is the agent.

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