BMO’s buffered leveraged notes on real estate ETF show strong buffer on short tenor

By Emma Trincal

New York, Feb. 22 – Bank of Montreal’s 0% buffered bullish enhanced return notes due Feb. 28, 2019 linked to the iShares U.S. Real Estate exchange-traded fund offer a defensive play on real estate investment trusts over a short period of time.

The payout at maturity will be par plus 150% of any fund gain, up to a maximum return of 15%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to 23% and will lose 1% for every 1% decline beyond 23%.

Mildly bullish

The notes are designed for investors who don’t see strong growth in the underlying ETF, which replicates an index mostly composed of REITs.

With a 15% cap over two years and the stated 1.5 times leverage factor, investors may earn no more than 7.25% a year on a compounded basis.

“Bank of Montreal has a good credit so they have funding rates that make pricing a little bit tougher,” a market participant said.

One characteristic of the structure was the relatively solid buffer contrasting with a moderate cap, sources noted.

“The notes are not very bullish,” this market participant said.

It only takes a 4.90% annual return in the index to lead investors to the cap.

Dividends

“The upside is going to be limited due to the short maturity and also the high dividend,” he said.

“It’s only a two-year. You don’t get the benefit of the rates moving up.”

The underlying fund yields 4.40%. The relatively high yield has an impact on the pricing of the underlying options.

The sale of a call option is how the issuer creates the cap. With a small amount of premium, the cap cannot be too high, he explained.

“The call premium is not worth much because of the dividends,” he said.

Higher dividends tend to lower the forwards on equity options since the stock price is expected to drop as a result of the dividend payments.

When the asset pays a high dividend, the value of the call options will be lower, which will reduce the issuer’s leeway to raise the cap, he explained.

On the other hand, a sizable amount of premium can be extracted from the put sale.

“That can give you a fairly attractive buffer,” he said.

Another factor facilitating the pricing of the buffer is the anticipated higher rates.

“It makes the cost of protection cheaper,” he said.

Price return

An industry source objected to the idea of giving investors exposure to an index usually sought out for its rich yield.

“What I don’t like about notes linked to REITs is the fact that you normally buy those stocks for the dividends. And the note doesn’t give you the dividends. It gives you a nice buffer. But you’re taking a bet on the price return of an asset class that’s not likely to do as well if you strip out the dividends,” this industry source said.

“I don’t see a scenario where the price return would go up considering that interest rates are on the rise.

“To me it’s cosmetics.”

The cap however was not his main issue.

“I wouldn’t come down hard on the cap. The cap is what it is. It’s much better compared to anything in the fixed-income space.

“It’s more about the perceived tradeoff,” the source said. “Structured notes are sold on the optics. Here it’s almost a 25% buffer on a two year.

“But you take this asset class you kill the dividends, almost 10% in dividends. Sure you’re going to get a good buffer.

“But I don’t think it makes sense to bet on an index designed for yield, not for appreciation.”

BMO Capital Markets Corp. is the agent.

The notes will price on Thursday.

The Cusip number is 06367TTD2.

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