RBC’s direct investment notes linked to small-cap focus list may be a tough sale, advisers say

By Emma Trincal

New York, May 30 – Royal Bank of Canada’s direct investment notes due June 8, 2018 linked to the May 2017 RBC Capital Markets U.S. Equity Small Cap Focus List had financial advisers who buy structured notes on a regular basis wondering why they should invest in this offering given the payout structure and the cost.

The notes are linked to a basket consisting of 10 equally weighted stocks from the RBC Capital Markets’ U.S. Equity Small Cap Focus List as of March 1, according to an FWP filing with the Securities and Exchange Commission.

The list components are American Equity Investment Life Holding Co., AMC Entertainment Holdings Inc., Colony NorthStar, Inc., Criteo SA, Masonite International Corp., Five Below, Inc., InterXion Holding NV, Mueller Water Products, Inc., Proofpoint, Inc. and Western Alliance Bancorp.

Advantages

The notes offer two main benefits: access to equity research and payment of dividends.

The return at maturity is based on the basket value. Each stock represents an RBC Capital Markets analyst’s best idea in a sector.

In addition, investors get a quarterly interest payment that reflects the dividends paid on each basket stock during the preceding quarter. Dividend payments are rare. Most structured notes provide exposure to price returns only, the buysiders noted.

However, they said the two benefits come at a cost, pointing to participation rate for the two types of payments.

At maturity, the payout is 97.75% of par multiplied by the basket percentage amount. As a result, the payout at maturity will be less than par if the basket percentage amount is less than 102.3%.

Similarly, the amount of dividends will be 97.75% of the sum of the dividend amounts for each of the basket stocks.

Less than one-to-one

“It’s like an actively traded small-cap mutual fund with a 3% annual fee ... except that in an actively traded mutual fund you would only pay a 1% expense ratio and you would get all the dividends,” said Jerry Verseput, president of Veripax Financial Management.

“I don’t see the advantage of this over a mutual fund.

“They don’t give you any downside protection.

“This is what an actively managed fund does: you get the dividends plus the full return minus the fund expense. I don’t really see the point of having this as a note since it costs you three times more.”

He was referring to the 97.75% participation rate, not to the 1.5% underwriter discount.

“The 1.5% fee is different. It’s built into the note. If you hold it to maturity, you get it back,” he said.

Skinny yield

While it looks appealing to get paid the dividends on a structured note, small-cap stocks are not known to be high-yielding securities, he noted.

Only four out of the 10 basket components pay a dividend. Two of those pay high yields. Colony NorthStar, a diversified REIT, has a 7.67% yield, and AMC Entertainment yields 3.24%. Another stock pays a 1.43% dividend, and the last one pays just about 1%. The average dividend yield of the basket is 1.33%.

“Normally small-cap stocks which are growth-oriented don’t pay a lot in dividends,” he said.

“They threw in there a couple of big ones to give you something, but it’s not much on average.”

Verseput said he does not really invest in the small-cap universe.

“I don’t need small-cap to get alpha. I get alpha from structured notes when they give me a hedge or some leverage. I don’t see any of that in there,” he said.

Piggy backing

Tom Balcom, founder of 1650 Wealth Management, agreed. In fact, investors would be better off buying the basket on their own, he said.

Because the issuer published the names of the 10 stocks, any investor could “piggy back” the investment and replicate the basket at a much lower cost.

“It’s only 10 stocks. Transaction fees for stocks are so low. Five bucks at Schwab or Fidelity, that’s a $50 cost for the basket ... and you get 100% of the upside and 100% of the dividends,” he said.

“Why would you use a note like that? You get no return enhancement, no buffer, no barrier. ...

“I guess you hope that those guys are good stock-pickers. Then why not buy the stocks on your own and hold them for even more than one year if you like them so much?

“I have to say I buy notes pretty often. I don’t get this one. It’s a head-scratcher.”

A good story

A financial adviser said investors are eager to invest in “themes” or equity research through notes linked to baskets made of analysts’ recommendations. Therefore RBC’s product is not necessarily a bad idea.

For instance, issuers such as Bank of Montreal have been very successful with notes linked to Raymond James’ Best Picks. The Canadian issuer usually prices no less than $100 million each time it brings those offerings to market, which is twice a year.

For instance in January, Bank of Montreal priced $310.24 million of 0% notes due Jan. 29, 2018 linked to a basket of 17 equally weighted stocks selected as Raymond James Analysts’ Best Picks for 2017.

“Stock-picking sells when you have a strong brand, and the equity analysts at Raymond James have been successful in picking stocks for a long time,” this financial adviser said.

“So with the Raymond James deals, the broker or the adviser selling the notes has a story to tell.

“Does Royal Bank of Canada have the same track record? I don’t really know. I think in this case, you hope that they do. But the track record is not that well-established. I guess it could be a story to tell but not necessarily an easy one to sell.”

RBC Capital Markets LLC is the underwriter.

The notes were expected to price on May 26 and to settle on Thursday.

The Cusip number is 78013GDY8.

© 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.