RBC's increase to call premium for notes linked to metals ETF not enough to boost return score

By Emma Trincal

New York, Aug. 26 - Royal Bank of Canada's upcoming autocallable notes due Sept. 3, 2013 linked to the SPDR S&P Metals & Mining exchange-traded fund have a below-average risk/return profile despite the recent increase of the call premium, said structured products analyst Suzi Hampson at Future Value Consultants.

The notes will be automatically called at par plus a premium of 10% to 12% per year if the fund's closing share price is greater than or equal to the initial share price on Sept. 4, 2012, March 1, 2013 or Aug. 26, 2013, according to a 424B2 filing with the Securities and Exchange Commission.

The exact call premium will be determined at pricing.

Repricing

Before the change announced Thursday, the call premium was expected to be 8% to 10% per year, according to an original filing dated Aug. 5.

If the notes are not called and the fund's final share price is at least 90% of the initial level, the payout at maturity will be par. Otherwise, investors will lose 1% for every 1% that the fund declines beyond 10%.

"This is for an investor who is ready to take some fair amount of risk and who is only mildly bullish on the sector, having no expectation of a return in excess of 10% a year," Hampson said.

"The call premium was increased to better compensate investors for the risk.

"The implied volatility is 50% now. When we priced it after the first filing, it was at 46%. And if you look back toward the first of August, it was below 40%.

"The higher the volatility, the higher the coupon as an autocallable essentially sells volatility." Hampson said that the increased call premium does not change the risk profile in itself but rather reflects the additional risk created by a pick-up in volatility.

However, the impact of increased volatility on risk is not always clear-cut, she said.

"You have a lot of moving parts with this type of structure," she said.

"More volatility could reduce your risk if it implies that you have a greater chance of being called; that's because once you're called, you no longer have any risk exposure. You get your principal back.

"On the other hand, you only have a 10% buffer. As a result, the increased volatility also increases your chances of breaching the downside trigger price.

"It's not clear-cut. It's hard to break out the different variables as they all affect one another in a non-linear fashion."

Credit and market risks

Riskmap, a Future Value Consultants rating that measures the risk associated with a product on a scale from zero to 10, is 6.53 for this product. The higher the riskmap, the higher the risk of the product.

The riskmap for these notes is higher than the average of all products (5.66) and the average riskmap of all similar products (4.73).

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

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

The credit risk is greater with these notes than it is with all other products as well as with products of the same structure category.

"Most autocallables are between one and two years," Hampson said.

"You have a two-year here, which is at the end of the scale for this type of product. It's going to increase your credit risk.

"If you compare it to the all-other-products category, which is dominated by many very short-term reverse convertibles pulling down the average duration in this category, you'll get a higher credit risk as well. Credit risk is closely linked to the length of the term."

The market risk component of the rating is also higher than that of similar products as well as for all product types, she noted.

"This is clearly because we have a fairly volatile underlying here," she said.

"Many of the products we rate are tied to broader indexes or funds, like the S&P 500 or funds in the MSCI family, which are quite less volatile.

"In addition, if you compare this to a reverse convertible, a lot of those have 25% buffers or at least they may have more than just 10%. That makes a difference in terms of market risk."

Low return score

The return score represents Future Value Consultants' opinion of the risk-adjusted return under reasonable and consistent forward-looking assumptions for underlying asset evolution.

For this type of rating on the same scale of zero to 10, the notes received a score of only 5.18.

The notes' return score is lower than for all products (5.97) and lower than similar products (6.19).

"For the risk associated with this product, the score simply means that your return is less than the average," she said.

"Put in another way, if you have to pick a highly risky fund like this one, you can find products with comparable volatility and higher returns on the market."

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.

Investors in the notes have a 58% chance of generating an annual return comprised between 5% and 10%. The probability of obtaining a return in the 10% to 15% bucket is only 5.5%, according to the table.

"When your call trigger does not require any growth in the underlying asset, when it only needs to stay flat, as it is the case here, you'll always have the greatest probability of kick-out around the first call date," she said.

"The first call is in one year. If you haven't kicked out on the first year, it means that your fund has gone down. In order to kick out on the next call date, it will have to increase, and the closer you get to maturity without being called, the harder it is to achieve."

Call protection

The notes cannot be called for the first year. After that, observation dates occur every six months.

"This is a positive as it reduces some of the reinvestment risk," Hampson said.

"Since the probability of an early call is always the highest with these types of flat trigger levels, you run the risk of being called after just one month or three when you have more frequent observation dates," she said.

In such case, while investors enjoy the same annual return as if they had been called after one year, their actual return is much less. Moreover, they are confronted with reinvestment risk.

Hampson said that when a note is called only one month or three months after pricing - as it is typically the case - investors do not enjoy the full actual premium even if, in annual terms, the rate of return remains the same.

"It's not the case here," she said.

Price, overall

The price score of the product is 3.48, lower than all products (5.14) and much lower than products with a similar structure (8.48).

Based on a scale of zero to 10, this score represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis and profit margins on the underlying derivative.

"This is low," said Hampson.

"It could mean that there is a lot of competition for this type of product. A lot of issuers are selling these types of notes, which may make pricing tighter," she said.

The overall score, Future Value Consultants' opinion on the quality of a deal, based on the average of the price score and the return score, is only 4.33 as a result.

It compares with an overall score of 7.33 for products of the same type and 5.55 for all products.

"The low price score combined with a return score below average explain the poor overall," Hampson said.

Wells Fargo Securities, LLC is the agent.

The notes (Cusip: 78008TMP6) will price in August and settle in September.

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