RBC’s $1 million bearish return notes linked to S&P 500 seen as rare in still-bullish market

By Emma Trincal

New York, May 19 – Royal Bank of Canada’s $1 million of 0% bearish return notes due June 17, 2016 linked to the S&P 500 index are an oddity in today’s market characterized by bullish and range-bound notes, according to data compiled by Prospect News.

Bearish notes allow investors to profit from a market decline in a similar way as a short seller would benefit from a drop in a stock price.

RBC’s $1 million issue of bearish notes is the first bearish product to price this year, according to the data.

If the index decreases from the initial level to the final level, the payout at maturity will be par plus double the percentage change – the initial level minus the final level – subject to a maximum return of 12.85%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will lose 1% for each 1% gain in the index.

‘Rare’

“I do think that bearish notes are rare while in the midst of a six-plus-year bull market as the ‘herd’ mentality of investors will lead them to buy bullish products and not bearish ones,” said Dean Zayed, chief executive officer of Brookstone Capital Management LLC.

Bearish views are most of the time expressed via inverse exchange-traded notes or notes that use an absolute return feature, which let investors profit from both ups and downs in the underlying as long as they are contained in a range. But those notes are more range bound than bearish in nature, sources noted.

Zayed offered an explanation for the very sporadic issuance of bearish notes.

“Manufacturers create products to sell, and frankly, bearish notes are a tough sell now even though we are at all-time highs,” he said.

“Let’s face it, the bull market feels good to most, and until the market tells us otherwise there is a tremendous amount of momentum into bullish products still.”

The S&P 500 index hit a new intraday high on Tuesday at 2,133 to close down at 2,127.83 in a choppy market.

“My overall view on the notes is that they can work as a hedge to protect an otherwise long-only equity position or portfolio,” he said.

“The analogy I would use is the use of protective puts that one can buy to protect or hedge an equity position. This note can accomplish something similar.”

Investors who do not want to take short positions or use options for hedging purposes have other recourses.

“Another example is the use of VIX funds to hedge a long equity position since they are negatively correlated,” he said.

“This note can be a core holding for one that is truly a bear but more likely can serve the specific purpose of protecting an otherwise traditional long-only portfolio with terms that are fairly competitive.”

Note with a view

Steven Foldes, vice chairman of Evensky & Katz / Foldes Financial Wealth Management, agreed with the concept of using the notes as a hedge. But the terms in his view are disappointing.

“This is an unusual structure,” he said.

“The term is relatively short.

“But whether my view is bullish or bearish, my comment is going to be the same.

“A note should be the mere image of a view. You should be able to use a note so that your view can make money for you. Structured notes are all about a view.

“This one reflects a bearish view. If you think that large caps are priced too high – we just hit a new all-time high today – if you look at the fact that we’ve been in a bull market for more than six years, I can understand that some investors might think we’ve got ahead of ourselves.”

But while there is nothing wrong with being bearish, investors in the notes are not in a position to “really participate in a down market,” because of the cap, he explained.

Modest returns

“After two times leverage, the best you can get is 12.85%. That’s nothing,” he said.

“When Ebola was in the news in October, we pretty much had a 10% decline. That’s pretty normal stuff.”

The S&P 500 fell to a low of 1,820.66 on Oct. 15, a 9.85% decline in less than a month from a high of 2,019.26 on Sept. 19.

“To get a maximum return of 12.85% on a 13-month note strikes me as a very modest win when you consider that if the index is positive you have no protection. If the S&P gains 5%, you lose 5%. If it goes up 15%, you lose 15%,” he said.

“There is no protection against the losses, and your victory is really modest.

“Any significant market decline of 15% or 20% is not uncommon, especially after the strong and lengthy bull market that we’ve enjoyed so far.

“Being capped out at 12.85% means that you may be right as it relates to your view but you’re not really allowed to truly participate.

“The cap is low and it makes this note a no starter.”

The degree of bearishness also plays an important role.

“This note will work if you’re slightly bearish and if the market is only down 5%, 6% and you double that up.”

But after a long-running bull market, “it’s the more bearish view that’s the more logical,” he said.

The right concept

Foldes explained that bearish notes are quite uncommon because “selling them to a client is contrary to what advisers do.”

It does not mean they should not be used, however. If the terms are attractive or well negotiated, an adviser may find these products beneficial to the client, he added.

“In today’s highly valued market having some kind of protection, using this kind of bearish view makes sense. We would use it as a strategy ... absolutely,” he said.

“The concept is good as a hedge. But this one does not give you a real hedge. You need a higher cap. We would want to have a minimum of 25% in terms of capping.”

Making changes

A few terms could be modified to try to make the notes more attractive to investors.

“I would rather have this note less levered at 1.15 or 1.25 or even unlevered so I can have the full benefit of a true downside, which means for me no cap as well as a protection against the market doing well,” he said.

“We would be willing to extend the note to a longer duration. An 18-month to 24-month would work fine. But I would like to have some modest protection, a 5% to 10% buffer if the market goes up. If the buffer can’t be priced, I would need a pretty big barrier on the downside.

“Finally, if you had to have a cap and assuming that I would extend the term to two years, I would need a meaningful cap in the neighborhood of 50%.

“Again, the concept of the notes makes sense as a pure hedge. Instead of buying puts, you could use a bearish note. You would just have to compare the cost of the puts versus owning something like this. But the terms of this note would not work for us.”

Zayed agreed that the cap could have been higher.

“As a pure hedge, that is not high enough as we know that the market could be down substantially more than that ... so it serves a purpose but falls short of meaningful hedging if we have much larger losses,” Zayed said.

The notes (Cusip: 78012KEG8) priced on May 14 and settled Thursday.

RBC Capital Markets, LLC was the agent.

The fee was 1.25%.

© 2015 Prospect News.
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