Bank of Montreal's upside booster notes tied to Russell 2000 pay off in narrow trading range

By Emma Trincal

New York, Jan. 14 - Bank of Montreal's 0% upside booster notes with barrier due Jan. 31, 2019 linked to the Russell 2000 index offer investors a chance to outperform the market, but the narrow market view associated with the trade as well as the opportunity costs incurred may reduce the odds of beating the small-cap benchmark, sources said.

If the index return is greater than 27%, the payout at maturity will be par plus the index return, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is between negative 10% and positive 27%, inclusive, the payout will be par plus 27%.

If the index return is less than negative 10%, investors will be fully exposed to losses.

Eye of a needle

Tom Balcom, founder of 1650 Wealth Management, pointed to the five-year duration, which increases the opportunity cost associated with the non-payment of the dividends. The Russell 2000 index has an annual dividend yield of 1.23%.

"A 27% return over five years annualizes out to be 4.9% with compounding. If it exceeds that, you're better off being long-only and get the 1.23% dividend yield," Balcom said.

While the notes appear to support a bullish view given that the upside above the 27% booster is uncapped, investors would really profit from the notes in a flat market, he said.

"The question is how bullish on the Russell are you? You really can't be too bullish on this deal. The only way you can outperform is if the index is flat for the next five years," he noted.

"You would outperform the most if the Russell was down 10% at maturity. That would be a loss of 2.08% per annum with compounding. So you have to have a view of an index trading sideways in this tight range between minus 2% and roughly plus 5%. And that doesn't even take into account the dividends that you're not receiving.

"If you want to have exposure to this market, the range of outcomes is so narrow, it really limits the potential to outperform the index."

Balcom said the he would not use the notes as he is bullish on U.S. small-cap stocks.

"I'm too bullish for this type of payoff. Historically, small caps have outperformed large caps. It's the place to be. Over the long term, you want to have small cap in the portfolio.

"I'd much rather have a long-only position so that I can have the liquidity, get paid the dividends and not be subject to credit risk. This is a good credit issuer, but it's a five-year term.

"The problem with this note is that even if your outlook is not very bullish, the trading range to get a positive outcome is quite narrow," Balcom said.

Opportunity cost

Michael Iver, chief executive of iVerit Consultancy and a former structurer, reached the same conclusions taking into account an overall opportunity cost that consists of coupon and dividend.

"What is the investor in those notes not getting? He is not getting a coupon, which is the deposit rate at Bank of Montreal, plus he's not getting the dividend yield of the index," he said.

With the Bank of Montreal's five-year deposit rate at 1.95% and adding to this the dividend yield, the investor's "opportunity cost" would be 3.18% per year, or about 16% over the period, taking into account compounding, he said.

The notes offer the advantage of the "booster" return, which is a digital payout. But the payout gives investors a chance to outperform the index under certain limits, he explained.

"Your 27% booster kicks in if the five-year point-to-point change in the index is between negative 10% and plus 27%, so the excess payoff relative to the market return is between 37% and 0%," he said.

"That is, if the market goes down 10%, the booster coupon of 27% represents 37% in excess payoff over the market because the investor receives 27% and avoids a 10% loss.

"If the market goes up by 27%, then the investor gets the booster coupon of 27%, and the booster does not provide any excess over the market return.

"The excess payoff is going down point to point to zero as the index appreciates up to the booster."

Breakeven

In the second stage of his analysis, Iver took into account the 16% opportunity cost incurred by investors in order to calculate the breakeven of the notes payout, which is an index increase of 11%.

"If the market rallies 11% and the investor gets the 27% booster coupon, the payoff of 16% over the market return is enough to exactly compensate for the 16% opportunity loss induced by the non-payment of dividends and deposit rate. So 11% is the breakeven," he said.

As the index appreciates, however, the benefits of the digital payout decrease, he explained.

He took the example of an index increase above the 11% breakeven. In such case, the 27% booster coupon would not be sufficient to compensate investors for the unpaid 16% return.

"If the market goes up by more than 11%, the investor would have been better off either investing in a Bank of Montreal-issued equity-linked note that pays the dividend yield and deposit rate or a deposit at Bank of Montreal plus index futures," he said.

"The 11% breakeven compensates the investor for the opportunity cost, above which the investor loses one-for-one."

Tight range

Iver said that overall, the zone of maximum profit for investors is in a tight range, between a 10% decrease and an 11% appreciation in the index.

"Any index return in that range over five years is good for the investor," he said.

"Surprisingly, the maximum benefit to the investor is when the market goes down by 10%. In this case, the booster coupon of 27% represents a 37% gain over the market return. If you subtract the 16% opportunity [cost], you get the 27% excess return represented by the booster."

Alternatively, if the index closes down 11%, investors will not receive the 27% booster, having breached the barrier.

"The investor in that scenario experiences the market loss of 11% and gave up 16% for a loss of 27%, which is the value of the booster," he said.

Given the narrow trading range associated with a profitable payout, Iver concluded that the notes are designed for investors with a very specific view.

"Since the excess return over the market and net of the opportunity cost is maximized at a five-year index change of minus 10% and diminished to zero at a positive return of 11%, this note is for someone who has a strong view that the market will trade very flat with a small, and highly confident, directional bearish bias over the next five years," he said.

BMO Capital Markets Corp. is the agent.

The notes will price Jan. 28 and settle Jan. 31.

The Cusip number is 06366RSU0.

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