Review: RBS offers income with downside protection on S&P 500

Royal Bank of Scotland is offering US investors a return even if the S&P 500 index falls by 20%, with the income coupons either at 1% or 8%, and the return of capital dependent on the year-to-year change of the index over the five-year term

This product is linked to the S&P 500 index and offers income coupons of 1% or 8% plus return of capital, depending on the annual performance of the index.

The annual return is defined as the percentage year-on-year change in the index: if it rises then investors receive a coupon of 8% for that year, and if it falls investors receive a coupon of 1%. For example, if the year-on-year change for the index is positive for the first three years of the investment and negative for the last two, investors will receive an income stream of 8% for the first three years and 1% for the remainder.

Capital repayment depends on the index performance over the five-year product term. If the final index level is higher than its initial level, capital is protected and investors will receive their capital in addition to any final coupon payments. If the final index level has fallen from its initial level by 20% or less, capital is protected and the investor receives the full return of capital at maturity. However, principal is not protected at maturity if, at maturity, the index has fallen by more than the buffer of 20% of the initial level. In this scenario, principal will be lost at the rate of 1:1 for any fall in the index below the buffer level. In the worst-case scenario, which would occur if the index hits zero, the investment will return just 20% of principal.

Downside payouts such as this are common in the US. They limit investors' downside exposure with a buffer zone, which in this case means the index can finish as much as 20% below its strike level without incurring any loss to the principal. This test is applied only at the final reading point.

This product would appeal to investors looking for an annual income stream who are prepared to take on some market risk and understand that, should the index fall by 20% or more, they will lose some of their capital investment.

Pricing and risk

The product consists of of a series of digital-style payments at the end of each year and a put at maturity with a strike of 80% and gearing of minus 100%. The digital payments pay 1% if the annual index change is negative and 8% if the index change is zero or positive.

The coupon payments are dependent on year-on-year growth in the index. The table on the right shows the pricing breakdown of the coupons for each year, along with the value of the coupons had they been dependent on the growth of the index from the initial value each year rather than year-on-year growth. Shown are the present values of each of the annual coupons. The prices include the effect of the discount factor, which also incorporates the estimated funding level of the issuer.

The expected value of the coupons decreases with each year. Coupons dependent on the growth of the index from the initial level are worth more to the investor than the year-on-year growth coupons. With year-on-year coupons, in order for 8% coupons to be paid every year the index needs to rise every year, whereas if the coupons were paid out with respect to the initial level the index would not necessarily need to rise each year for the maximum coupon to be paid. If the issuer had chosen to offer coupons based on the total growth in the index for the same total price, then one or both of the potential coupon amounts would have to be reduced.

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