RBC's absolute return notes tied to S&P offer potential alpha, may stack up better than peers

By Emma Trincal

New York, Sept. 26 - Royal Bank of Canada's 0% absolute return barrier notes due Oct. 15, 2015 linked to the S&P 500 index offer attractive terms, giving investors a potentially better alternative to a direct equity investment and competing favorably with other absolute return notes, also called "twin-win," sources said.

The structure presents an American-option type barrier of about 80%, no cap on the upside and an absolute return feature.

A barrier event will occur if the index closes below the barrier level, 76.75% to 79.75% of the initial level, on any day during the life of the notes. The exact barrier level will be set at pricing, according to an FWP filing with the Securities and Exchange Commission,

Sources made the most conservative assumption with a hypothetical barrier level of about 80%.

If the index finishes above its initial level, the payout at maturity will be par plus the index gain.

If the index falls and a barrier event has not occurred, the payout at maturity will be par plus the absolute value of the return.

If the index falls and a barrier event has occurred, investors will fully share in the index's decline.

Better than the S&P 500

Kirk Chisholm, principal and wealth manager at NUA Advisors, said that the notes may be a better alternative than an outright equity investment in the benchmark as they give investors a chance to generate alpha.

"It sounds interesting. There is always a downside in each of those products. You get something, but you have to give up something else," he said.

"For instance, when you get two-times the upside, you usually have a cap.

"This one is puzzling because you still have all the upside. You also have the barrier for the protection and the absolute return."

One of the aspects of the "trade-off," he said, is giving up the 2% annual dividend yield paid to investors in S&P 500 funds.

"So let's see. You're missing out on 4%, but you get a pretty strong payoff since you can gain two ways in an up and a down market. I like it. It's very interesting," he said.

"Compare this with buying the S&P thinking now is a good time to put money into it. I'd say this note is a better alternative.

"You can really outperform the S&P in a downside scenario and generate excess returns. If the market drops no lower than 20%, you'll end up positive for the period.

"From my perspective, the trade-off is definitely worth it, in part because past that 20% decline, your downside is just the same as the S&P."

The trading limitations on the secondary market, a risk common to all structured notes, are another side of the trade-off, Chisholm said.

"Obviously liquidity is an issue. However, if you wanted protection, you could always look at buying puts. If things turned out to be negative, you could offset that by hedging it out by buying puts or inverse S&P ETFs. There is a variety of ways to mitigate this risk."

Investors would be at risk if a quasi-bear market or bear market arrived and the S&P 500 approached or hit the barrier threshold, he said.

"But historically, if you go back, having a 20% downturn doesn't happen very often," he said.

"Also, we have the luxury of having the Bernanke put. There's a lot of support that pushes up the market, at least for the time being.

"If QE ends, I suspect we'll see some correction, but it's not necessarily going to be 20%, and you can always hedge the risk yourself.

"If you're going to invest in the index, this is a pretty reasonable alternative. You have the liquidity and the dividend issue that you're giving up, and that's the trade-off. But it gives you the potential to make money from negative 20% to infinity, and that's a wide range of possibilities.

"I would definitely give up the 4% dividend for that trade-off, especially when it's easy to hedge off the risk."

Best of class

John Farrall, senior vice president, director of derivatives strategies at PNC Wealth Management, said that the absolute return structure used in the notes is regaining favor in today's market. He added that this particular product has better terms than a lot of its peers.

"A couple of issuers have told us that these are popular trades right now, especially in the light of the FOMC decision not to taper just yet," Farrall said.

"They used to be called twin-win. They're designed for people who don't know if the market is going to go up or down but who think that should it go down, it won't go down that much. You're making money on both directions as long as the return is not terribly negative. You just assume the market is not going to sit still."

The Fed's decision last week to leave its stimulus unchanged took the market by surprise, he said.

"A lot of investors are not sure which way the market is going to go as a result of that," he said.

"We see that in the derivatives world; people are buying a lot of puts or they're buying a lot of calls."

The concept of the deal is the same as that of other absolute return or twin-win notes, he said.

"You're long put: If you go down, you're up. And you're long call: If you go up, you're up," he added.

But the deal offers additional advantages compared to other similar products, he noted.

"This structure is nice because it's only a two-year. It's hard to find funding inside three years," he said.

"The risk is that things go wrong, but you're not worse off than being long only anyway.

"Another advantage of this structure is that it's uncapped. Many twin-wins have a cap on the upside. Of course, if you had a 50% cap for instance, they may give you a larger range on the downside, like 30% instead of 20%. Still, being uncapped is a plus."

Finally, he said that other twin-win notes offer an asymmetrical payout on the downside and the upside in the event of an absolute return scenario. For instance, investors may gain half of the index decline instead of the entire rate of decline.

"They give you one for one on the upside but only 0.5 for one on the downside," he said.

"So if you're up 5%, you're up 5%, but if you're down 5%, you're only up 2.5%.

"I would say that getting uncapped upside on a two-year with a one for one on the downside is quite competitive. It's a very attractive structure.

"RBC has been particularly good at trading the SPX. They have a pretty good SPX trader from what I've heard."

The term "SPX" refers to the S&P 500 index.

"With this Fed tapering delay, this deal and others are going to be more and more popular because no one really knows which way the market is going," he said.

RBC Capital Markets, LLC is the agent.

The notes will price Oct. 9 and settle Oct. 15.

The Cusip number is 78010UFE2.

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