RBC’s $458,500 buffer gears on stock basket offer exposure to underweight sectors in S&P

By Emma Trincal

New York, June 1 – Royal Bank of Canada’s $458,500 of capped buffer gears due Nov. 30, 2022, linked to an equally weighted basket of stocks provide access to less represented sectors in the equity market allowing investors to complement a broad S&P 500 index allocation, an adviser said.

The basket consists of Alcoa Corp., ConocoPhillips, Deere & Co., Freeport-McMoRan Inc., FMC Corp., Barrick Gold Corp., Mosaic Co., Newmont Corp., Pioneer Natural Resources Co. and Steel Dynamics, Inc., according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus 2 times any basket gain, capped at par plus 27.8%.

If the basket finishes flat or falls by up to 10%, the payout will be par.

Otherwise, investors will lose 1% for every 1% that the basket declines beyond the 10% buffer.

Market themes

Tom Balcom, founder of 1650 Wealth Management, said the underlying basket was unusual.

“Obviously, it’s a play on infrastructure and commodities. You have gold miners in there, aluminum, copper, and oil. Other stocks are more geared toward agriculture and machinery like Deere,” said Balcom.

“It’s also a play on inflation. Right now, people are buying commodities as a hedge against inflation. We have a huge rally. This basket with its oil companies and miners is built around that theme.”

“If you want to position yourself for the global cyclical recovery and get some protection if the economy is overheating that’s a good place to be.”

Materials

The most represented sector in the basket is materials with seven stocks. Those are Alcoa, a big aluminum producer, Freeport-McMoRan, a mining company, Barrick and Newmont, two gold miners, FMC, a developer of crop protection chemicals, and steel producer Steel Dynamics.

Materials represent the third best-performing sector this year after energy and financials, according to Select Sector SPDR website.

The Materials Select Sector SPDR exchange-traded fund has gained more than 20% for the year. The energy Select Sector SPDR is up 37.8% and the financials Select Sector, 29%.

“These are solid companies. They’re not going anywhere. So, you may see declines in the stock prices, but the buffer provides a degree of protection,” said Balcom.

Complement to the S&P

Perhaps one of the main appeals of the notes was to use the basket in combination with a broader market exposure.

“Industrials, energy and materials are underweighted in the S&P,” he said.

Materials account for 2.56% of the S&P 500 index and energy, 2.53%.

“This note gives you a more even exposure to the S&P. When you invest in the S&P, you have 26% in technology. The other sectors are underweight. This is a good complement to your exposure to the broad index,” he said.

Selection

The buffer and the diversification offered by the basket made the product relatively defensive.

“I’m OK with 10 stocks. I’d be curious though to know how they picked the components. Why ConocoPhillips and not Exxon? What were the selection criteria?” he said.

The prospectus does not provide any details on the selection methodology of the securities.

“But I like the thesis there. You can even out your exposure to the S&P. You’re making different sector bets than when you buy the benchmark.”

Structure

Donald McCoy, financial adviser at Planners Financial Services, said he liked the notes.

“The stocks have probably different levels of dividends. You have to give that up,” McCoy said.

The average dividend yield of the basket is 1.5%.

“But you’re getting 2x leverage and a buffer. There’s a lot to like here,” he said.

McCoy said the 27.8% cap over 18 months was relatively high. On a compounded basis, investors may expect to earn up to 17.75% per year if they reach the cap, which can be attained if the basket increases by 9% a year.

Mildly bullish view

“The only downside here is the commodity rally. Commodities have gone up a lot. If prices drop, the holdings in the basket could suffer,” he said.

“Obviously if you’re super bullish on commodities, you’ll probably own the stocks individually outright.

“We had a strong run up. Maybe inflation might not rise as strongly as people anticipated.”

The notes would be suitable to a moderately bullish outlook, he said.

“You eliminate some of the risk and you’re boosting your return.

“You just have to hold the view that this big rally won’t have legs,” he said.

All the sectors represented in the basket have outperformed the broader S&P 500 index, he noted.

“The fact that those sectors have done so well recently is a good reason to limit your expectations. Looking forward getting the 2x with a cap is a sound strategy, especially if we’re only looking at 18 months,” he said.

UBS Financial Services Inc. and RBC Capital Markets, LLC are the agents.

The notes (Cusip: 78014U152) settled on Friday.

The fee is 0%.

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