Advisers weigh out digital versus leverage payouts with RBC’s $2.53 million deals on REIT ETFs

By Emma Trincal

New York, June 14 – Royal Bank of Canada recently priced two offerings on the iShares U.S. Real Estate ETF with very similar terms. The maturity date is July 13, 2023. The deals priced on the same day for $2.53 million each. The buffers are identical. Only the upside payoffs differ – one note being a digital product, the other, a return enhanced note with a cap.

For the first deal, investors at maturity get par plus 16.25% if the underlying fund is flat or positive. In the second issue, the upside is par plus 2 times the fund gain capped at 21%.

On the downside both products show a 10% geared buffer. Investors will receive par if the fund declines by 10% or less and will lose 1.1111% for every 1% that the fund declines beyond 10%.

Digital preferred

Steven Foldes, wealth manager and founder at Evensky & Katz / Foldes Financial Wealth Management, had a clear favorite.

“I like the digital better. As long as you’re up, or even flat, you get a nice return, while with the other, you have to get to the cap. You need the price to go up,” he said.

The note has a 13-month tenor. On an annualized basis, the compounded maximum return would be 19.3%, which would be achieved if the ETF rose 9.65% per annum.

“The leveraged one has a higher potential return of 21%. But again, with this payout, the ETF has to go up while it doesn’t have to with the digital. The cap is so close to the digital, it doesn’t make any sense to take that gamble to get 4.75% more if it means you have to be up twice that extra gain to get there.

“If the note had a much higher cap than 21% or if it was uncapped, I would consider the leveraged play. But not this one.

“I’d rather have the sure thing with 16%,” he said.

While the cap was a drawback, the general idea of a leveraged return made sense in the current market, he added.

“Real estate is down a lot this year. With such decline, ideally, I would rather use leverage for the potential upside. If we have a reversion to the mean, there is an opportunity to get more than 21%.”

If he had to reconstruct the leveraged note, Foldes would either raise the maximum return above 21% or lower the leverage multiple in order to eliminate the cap altogether.

“But since this is not how the note is designed, if I had to pick one, I would go with the digital because the odds of success are much higher. You’re more likely to get 16.25% than to get the extra 4.75%,” he said.

Buffer

The 10% geared buffer common to both deals was satisfactory, this adviser said.

“It’s nice to have if things don’t go well.

“Over long periods, I don’t like buffers because they’re not needed. But for a short-term note, having a 10% buffer is worthwhile,” he said.

The “big decline in the ETF this year” provided an additional margin of safety, he said.

The underlying share price closed at $87.22 on Tuesday, or 25.5% off its Dec. 31 high.

“You want the downside protection over a short-dated note especially for the next 13 months,” he said.

“We have a lot of volatility in the market. There is the situation in Ukraine that could go on for a number of months. Interest rates are rising. It’s a very cloudy, uncertain future.”

Wireless REITs

Tom Balcom, founder of 1650 Wealth Management, said both offerings were appealing.

“I like them both. If you end up with 16% or 21% over 13 months, you can’t be too upset,” he said.

However, investors should have a view on the economy before making a decision.

“You can put an argument for both trades.

“If we can avoid a recession, the leveraged notes are better. If not, the digital one is preferable because you earn a nice return even if the market doesn’t do anything,” he said.

However, predicting the economy over the next 13 months is “a very difficult task,” he said.

One important way to assess the risk, he noted, was to look at the fund’s top holdings and estimate how resilient each company may be during a recession.

“American and Crown Castle are cell phone tower REITs. They’re big holdings in the fund and they’re pretty much insulated from a recession. Everyone uses a cell phone,” he said.

American Tower REIT Corp. is the top holding with a 9% weighting. The company owns and operates wireless and broadcast communications real estate.

Crown Castle International REIT Co., the third top holding, has a 5.84% weighting. It is a REIT, which provides access to wireless infrastructure.

Recession risk

“Others like Simon Property are much more vulnerable. They operate shopping malls. A recession could hit their bottom line really hard,” he said.

The severity of the recession would also have an impact.

“If the economy really tanks, people will sell everything, and it won’t matter what’s in the ETF. It’s what I call the ‘get me out’ trade or GMO.”

All things considered, Balcom said he would lean toward the digital notes.

“I’m a big fan of digitals in general,” he said.

“16% is less than 21% but it’s guaranteed if the fund is not down. With the other one, if the ETF is up 2% you only get 4%.”

The difference between 16.25% and 21% was not substantial enough to lead investors to give up the digital payoff.

The Cusip number for the geared buffered digital note is 78016FLV4.

The Cusip number for the geared buffered enhanced return product is78016FLU6.

RBC Capital Markets, LLC is the agent.

Both offerings carry a 0.25% fee and settled on Monday.

© 2015 Prospect News.
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