RBC's $42.81 million of one-year Stars linked to S&P 500 topped last week in a bid for yield

By Emma Trincal

New York, Aug. 22 - Royal Bank of Canada's $42.81 million of 0% Strategic Accelerated Redemption Securities due Aug. 30, 2013 linked to the S&P 500 index, last week's top offering, had sources saying that investors put money into the deal in a quest for yield.

The potential yield is an 8.86% annualized call premium. The call is triggered if the index closes at or above its initial level on Feb. 15, 2013, May 17, 2013 or Aug. 23, 2013, according to a 424B2 filing with the Securities and Exchange Commission.

If the notes are not called, investors at maturity are protected up to a 5% buffer but are exposed to losses beyond that.

Money at work

"It's a nice tactical play to keep your money working," a market participant said.

"It's the type of structure that goes back to Merrill Lynch days when they did a good job at selling these autocallables. They were sold as short-term, tactical opportunities to get yield."

Bank of America Merrill Lynch was the agent on last week's offering, which priced Aug. 16.

The notes must have been of interest to investors looking for yield, the market participant said.

"I don't disagree with the structure at all," he said.

"If the index is up or stays the same, I get my principal back after six month with a 9% coupon per annum.

"If you compare it with other short-term fixed-income products, how far on the yield curve do you have to go out to get 4.5%?"

Early exit

Investors in the notes must accept the idea of a potential early redemption, the prospectus warned. In the event of a call, an early exit exposes investors to an additional risk.

"Now what I don't like is that every time the note gets called, you have to reinvest your principal," the market participant said.

Statistically, a call is most likely to occur on the first observation date for autocallable products, said Suzi Hampson, structured products analyst at Future Value Consultants.

"You have the reinvestment risk, although they have reduced it here by making the notes non-callable for the first six months," the market participant said.

Making the notes non-callable for the first half of the term is a positive feature, he said, as investors often expect to receive the full annualized yield - in this case almost 9% - but get disappointed when they actually get only a quarter of it.

"What's nice is that you get your money working for six months with a 4.5% [rate]. It's better than a money market fund, although obviously you can't compare the two. But if you're confident enough in the equity market, it's a way to capture some of the performance," the market participant said.

Another factor behind the success of the deal is Bank of America's distribution network via Merrill Lynch, he said. "Usually they do things with places like Royal Bank of Canada, an issuer with a very good credit. You probably eliminate the perception of credit risk by having RBC issuing this. And if you are loaded with Bank of America paper, this can be a diversification tool," he said.

Tiny buffer

Andrew Valentine Pool, main trader at Regatta Research & Money Management, was less focused on reinvestment risk and more concerned with market exposure and risk versus return.

He stressed that investors could lose up to 95% of their principal if there is no call and that the upside is limited to the call premium regardless of the index performance.

"Five percent isn't much. Most people are thinking that the market will be flat or higher, but that's not good enough for us. I would like to see a bigger buffer," Pool said.

"If I'm going to get 8.86% and almost no protection, why wouldn't I get some yield elsewhere, in some limited partnership fund, for instance?"

He mentioned the Center Coast MLP Focus fund, a limited partnership mutual fund with a 6.28% yield.

"I am holding this fund in our stable growth portfolio. We think that over the long term, the U.S. will become more energy independent. That's why I think limited partnerships are a good play for yield for the next 10 years," he said.

"I know that everyone is hungry for yield. But why would I want to get exposed to equity market risk and get not even 9%? If it was 11% or 12%, I would be willing to risk it.

"It's not a bad deal. It can see why people liked it. They want yield. You can get your money back in six months or in a year with a decent coupon. I just don't think there is enough downside protection."

The notes (Cusip: 78011D401) carried a 1.25% fee.

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