RBS' 5.25-year principal-protected notes linked to SPDR Dow offer value, income substitute

By Emma Trincal

New York, Sept. 9 - Royal Bank of Scotland plc's 0% market-linked notes due Jan. 5, 2017 linked to the SPDR Dow Jones industrial average exchange-traded fund trust offer good value for investors trying to find an income alternative to fixed-rate bonds, said structured products analyst Suzi Hampson at Future Value Consultants.

The product offers principal protection subject to the credit risk of the issuer, according to a 424B5 filing with the Securities and Exchange Commission.

"With those products, you have the credit risk plus the risk of not generating any gain at maturity," said Hampson.

"But for some looking to get more income than in a five-year bond, it's worth taking the risk for a product that can potentially pay an uncapped return."

The payout at maturity will be par plus 100% to 110% of any trust gain. The exact participation rate will be set at pricing. If the trust falls, the payout will be par.

Very low risk

The notes show a level of risk well below the average of all structured products rated by Future Value Consultants and slightly lower than similar principal-protected notes as measured by the riskmap, said Hampson.

The riskmap is Future Value Consultants' score on a scale of zero to 10 that reflects the risk associated with the product. The higher the riskmap, the higher the risk.

This product received a 2.52 riskmap versus an average of 5.56 for all products and 2.7 for similar products.

The riskmap compares the average product underperformance (relative to cash) with the average underperformance of five sample assets of different volatility levels. This risk rating equates the risk of the products against the five hypothetical assets.

"Obviously, the low riskmap reflects the full principal protection," said Hampson.

The riskmap is also the sum of two risk components: market risk and credit risk.

Because of the 100% principal guarantee, market risk for the notes is limited and the market riskmap is only 0.76 compared to 5.13 for all other products and 1.16 for similar products.

Credit risk

However, the 1.75 credit riskmap is higher than the 0.43 average for all other products, she noted.

"This is a five-year term, and it's very long for a structured product if you compare it to a reverse convertible. The longer the maturity, the higher the credit risk," she said.

In addition, she noted that the credit default swap spreads for Royal Bank of Scotland are 300 basis points, which is higher than the average U.S. bank.

"We've seen some increase in CDS spreads over the past few weeks. A 300 basis point level is quite high. It indicates that the funding rates are high," she said.

"I imagine that's how the issuer had more room to buy the options and offer attractive terms."

Above-average risk/return

Future Value Consultants' opinion of the risk-adjusted return is delivered via its return score.

The rating is calculated from five key assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. The research firm calculates a risk-adjusted average return for each assumption. The return score, on a scale of zero to 10, is the best of these five returns.

The notes received a return score of 8.67, more than the average of all products at 6.03 and also slightly more than products with a similar structure, which show an average score of 8.02.

"For the amount of risk you're taking, your potential return is high, which is what a high risk-adjusted return means," she said.

"The uncapped return plays to the benefit of the return score."

Modest return probability

The return score derives from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

The performance is modeled based on a series of parameters, which include volatility, dividends and interest rates among others.

The probability table associated with this product shows that the highest probability, 72%, is for the investor to receive a gain between zero and 5%, which is the lowest gain bucket on the chart.

"This is not surprising from a principal-protected product," she said.

"You wouldn't expect that type of product to have a high probability of massive returns because you're not taking the risk.

"With a principal-protected note, you expect the highest probability to be around the risk-free rate plus the funding level of the issuer."

One other explanation for the large probability of generating a zero to 5% profit, she explained, is that this bucket includes all the probabilities of the index return falling below zero at maturity. In such case, the investor would receive par, an amount of return equal to zero.

Price score high, temporary

Future Value Consultants' estimate of the total costs taken out of the product from direct fees and profit margin on the underlying derivative is measured via the price score on a scale of zero to 10.

The product scored 9.46 in that category, which is unusually high, said Hampson.

"The issuer gave a range between 100% and 110% for the participation rate. We don't see that in the U.K. We always have a specific number. But it seems to be the way a lot of the products are put into the market in the U.S.," she said.

"Our rule is to pick a number that represents 75% of the range. So we picked a participation rate of 107.5% in order to score the product.

"If the participation rate was only 100%, the price score would naturally go down.

"The price score gives you an indication but not a complete picture."

Future Value Consultants offers its opinion on the quality of a deal with its overall score, the average of the price score and the return score. These notes received a 9.06 overall score.

"The high return and price scores give you an overall that's quite good," she said.

"The two components suggest that the product has good value and a good chance of generating a decent return."

RBS Securities Inc. is the underwriter.

The notes will price on Sept. 30 and settle on Oct. 5.

The Cusip number is 78009PBU4.

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