Royal Bank of Canada Sells Largest Four-Stock ‘Worst of’ Note
Royal Bank of Canada sold $5.05 million of U.S. structured notes tied to the worst performing of four energy stocks, the largest such offering linked to that many companies in at least two years.
The one-year callable notes, issued Jan. 23, yield 10.5 percent as long as Exxon Mobil Corp., Halliburton Co., Chevron Corp. (CVX) and Baker Hughes Inc. (BHI) don’t fall below 70 percent of their initial values on any day, according to a prospectus filed with the U.S. Securities and Exchange Commission. If any of them do, losses will be based on the stock that fell the most, with all capital at risk.
Sales of so-called “worst of” notes climbed last year as correlation among U.S. stocks dropped, increasing the risk of losses in the investments, according to data compiled by Bloomberg. The four stocks in the Royal Bank of Canada note have correlations as low as 0.308 with each other, “which means that one can zig while the other zags,” said Alec Levine, an equity-derivatives strategist at Newedge Group SA in New York.
Of the four companies, “Halliburton’s the lemon,” Levine said in a telephone interview.
Service providers such as Halliburton and Baker Hughes are facing smaller margins in contracts with Petroleo Brasileiro SA (PETR4), which accounts for about 92 percent of Brazil’s oil output, as the state-run producer seeks to reduce costs. A slowdown in China’s growth might also hurt the oil services company’s value, Levine said.
Halliburton expanded too quickly before drilling cutbacks by Petrobras, Ted Harper, who helps oversee about $10 billion at Frost Investment Advisors LLC, including Halliburton shares, said by telephone.
When asked for comment, Susie McMichael, a spokeswoman for Halliburton in Houston, referred to the company’s Jan. 21 conference call for fourth-quarter earnings. “With regards to Latin America, we expect 2014 to be a challenging year with fairly steady activity in all countries except Mexico and Brazil, both of which are in transition,” David Lesar, Halliburton’s chief executive officer, said during the call.
Kait Conetta, a spokeswoman for Royal Bank of Canada in New York, declined to comment on the offering.
Structured notes are debt packaged with derivatives that can offer customized bets for individual investors. Banks earn fees and raise money from them. Derivatives are contracts with values derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
The four companies in the note are involved in similar but distinct industries. Exxon Mobil (XOM), the world’s largest oil company, and Chevron, the world’s second-largest by market value, produce oil. Halliburton and Baker Hughes provide oil services, such as hydraulic fracturing or drilling.
In January, Halliburton’s stock has been the most likely to move in the opposite direction of Chevron’s since at least 2004, according to Bloomberg data of historical prices over 120-day periods.
On the day the notes were issued, its stock movements had a correlation of 0.308 with Chevron, 0.447 with Exxon Mobil, and 0.616 with Baker Hughes, Bloomberg data show. A correlation closer to one means that prices move more in tandem.
While historical correlation can be a “useful baseline” for assessing these notes, that “can also break down if something fundamentally has changed,” said Peter Cecchini, chief strategist and global head of macro equity derivatives at New York-based Cantor Fitzgerald LP.
The CBOE S&P 500 Implied Correlation Index, which uses options to measure expectations about whether companies in the S&P 500 will move in unison, fell 27 percent in 2013, closing at 49.8. The gauge has risen 12 percent since then to 55.88.
“Worst of” notes fit the criteria for “complex” securities, Richard Ketchum, chief executive officer of the Financial Industry Regulatory Authority, said at an industry conference in September 2012.
RBC increased its sales of the notes last year, Bloomberg data show. Canada’s second-largest bank by assets sold $64.9 million of the products in 2013, more than three times the $19.7 million sold the year before. It has issued $10.1 million this month.
Most worst-of notes since January 2012 are tied to the values of two or three stocks or indexes, Bloomberg data show. The Royal Bank of Canada (RY) note is the largest worst-of offering tied to four or more stocks during that time.
The bank, which distributed the notes for a 1.25 percent fee, can redeem the securities in four months, according to the prospectus. The Toronto-based lender estimated their initial value at 97.5 cents on the dollar.
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