RBC's autocallable notes on Energy Select Sector SPDR give bulls high call premium, buffer

By Emma Trincal

New York, July 22 - Royal Bank of Canada's upcoming 0% autocallable optimization securities with contingent protection due Aug. 2, 2011 linked to the Energy Select Sector SPDR fund are designed for investors who are betting on the recovery of a sector that's been battered by the oil spill disaster, sources said.

For investors who anticipate that the sector will stay stable or appreciate, the investment gives a good potential upside with an attractive partial protection on the downside, and some may even want to use it as a hedge.

If the fund's shares close at or above the initial share price on any of the monthly observation dates, the notes will be automatically called and investors will receive par of $10 plus an annualized call premium of 14% to 18%, according to an FWP filing with the Securities and Exchange Commission. The exact call premium will be set at pricing.

The observation dates are Aug. 25, Sept. 24, Oct. 25, Nov. 23, Dec. 27, Jan. 25, 2011, Feb. 22, 2011, March 25, 2011, April 25, 2011, May 24, 2011, June 24, 2011 and July 27, 2011.

If the notes are not called and the final share price is greater than or equal to 75% of the initial price, the payout at maturity will be par.

If the final share price is less than 75% of the initial price, the payout will be par plus the fund return.

Bullish or neutral

Steve Doucette, financial adviser at Proctor Financial, said that he uses diversified investments and does not typically make sector picks.

He said that he did not have a view on energy but that he liked the protection offered by the buffer.

"If I decided to have an allocation to energy, I might consider it," he said. "It's a reasonable way to collect some call premium if you are bullish on energy. You have some downside protection," he said.

Doucette noted that investors only need to see the fund remain stable on any of the observation dates in order to get the call premium; as such a typical investor could be either bullish or neutral on the sector. "And if it goes down by less than 25%, you still collect par at the end," he said.

Hedging

Even if the underlying fund was to finish below the initial price, he said, as long as it does not close below the 25% trigger, investors in the notes would outperform a direct investment in the equity.

"The buffer could give you a way to hedge a long exposure on the sector," he said.

For instance, a decline of 15% would protect an investor in the notes from any losses while an equity investor who bought the exchange-traded fund would have lost 15% of his initial investment, he explained.

"So you might not be earning anything, but you're not losing your principal either. And because of that, you are outperforming the fund," he said.

Call dilemma

Investors often buy autocallables for the early redemption triggered by the call, as it frees up their capital, industry sources said. But reinvestment risk in those cases can be an issue, they noted.

"If your securities are called, you may not be able to reinvest the proceeds at a comparable rate of return," the prospectus warned in its "key risks" section.

Doucette agreed that it was a risk.

"Getting your principal back early is good theoretically. But then you have to figure out what to do with it," he said.

Sources said the appeal of the investment will closely reflect the investor's market view.

Bad for bears

Bruce Greig, portfolio manager at Altin Holdings, a commodity pool operator, said that "the notes make sense for a bullish investor" but that "personally, I would not consider it because my outlook on energy is bearish."

"It's definitely some kind of synthetic option favoring the bullish investor," he said.

"Just like an option, you have the protection offered here with the buffer. It's not an unlimited protection though, and there's still risk you need to assume," he said.

But Greig said that he was bearish on energy both on an "absolute" and "relative" basis.

"One a relative basis, I compare it against the market. And the energy sector is currently underperforming the S&P [500] by a fair amount on a momentum basis," he said.

The S&P 500 has declined by 1.92% for the year, while the Energy Select Sector ETF has lost 6%. The ETF tracks the energy sector of the S&P 500.

"On absolute terms, the fund looks bearish if you chart it. Energy is one of the weaker sectors; this is enough for me to stay away from it," he said.

Worthwhile for others

But Greig said that for investors who are not bearish like himself, the notes may represent a good opportunity.

"I think it's a worthwhile product for someone who seeks exposure to the energy sector. There's potential upside you're giving up [above the call premium], but you still have a very healthy potential return. Getting close to 20% ... no one is going to complain about that. For someone bullish on energy who doesn't want to create a synthetic option, it may make sense depending on the cost," he said.

The top two holdings of the ETF are Exxon Mobil Corp. and Chevron Corp.

BP plc is not included in the fund.

The notes are expected to price July 27 and settle July 30.

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

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