Bank of Montreal range accrual notes tied to iShares Russell offer income but risk principal

By Emma Trincal

New York, Oct. 1 - Bank of Montreal's range accrual notes with contingent downside protection due Oct. 30, 2015 linked to the iShares Russell 2000 index fund offer an attractive income potential, but the equity-based strategy is not for conservative investors, financial advisers said.

"This is not riskless. You're only mitigating the risk at best," said Scott Cramer, president of Cramer & Rauchegger, Inc.

The notes will accrue interest at 8% per year multiplied by the proportion of days on which the fund closes at or above 80% of the initial price. Interest is payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

If the final share price is at least 80% of the initial price, the payout at maturity will be par. Otherwise, investors will be fully exposed to losses from the initial share price.

Income

"As an income play, I do believe that it seems reasonable as part of an overall income portfolio for someone who doesn't want to be in the fixed return market," Cramer said.

"It may be used as an alternative to a dividend-paying stock portfolio or in combination with it because you're probably getting a higher income in a good market than you would get in dividend stocks and you do have some downside protection.

"But make no mistake about it: if we have a market downturn, you could lose money. That can happen without a doubt. The problem with those long-term point-to-point barriers is that if it breaks before maturity, you could be in trouble."

In addition, he said, investors could receive little or no interest at all. That's because, as stated in the prospectus, interest will not accrue on any day on which the closing price is not above 80% of the initial price.

Another drawback is the limited upside, which can never be more than 8% a year, even if the fund is up significantly, according to the prospectus.

Cramer said that actual capping should not deter income-seeking investors.

"You're not participating in the underlying. It doesn't have to go up. It just doesn't have to go down a whole bunch," he said.

"If you lose a few days of interest, if you get an average of 5% over this and never lose any money, that's really not bad. On a scale of one to 10, I would rate this as a seven."

The notes, while linked to an equity benchmark, are really designed for income, he said.

"No investment exists in a vacuum. This would be an attractive product to use as part of a whole. It's an income strategy," he said.

Barrier

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that investors who believe that the small-cap benchmark will trade in a range over the next three years would be likely buyers of the product as a way to boost income. But he does not like the asymetrical risk/reward profile, he added.

"With those barrier products, I always look at the odds of breaching that trigger level," Kalscheur said.

The Russell 2000 has shown a 21.4% standard deviation over the last three years, he noted. Over the past five years and 10 years, its standard deviation has been 24.6% and 20.6%, respectively.

"Regardless of the period, the standard deviation has been consistently over 20%. Including 2008 will drive up the standard deviation, but even if you smooth it out, it's still over 20%. This tells me that you have a good possibility of breaching that 20% level. It may not be very likely, but it's definitely hypothetically possible," he said.

"You're betting that the Russell will be positive but that it's not going to shoot the lights out. If you're slightly pessimistic or moderately optimistic about the Russell 2000 for the next three years, at least you're going to get something out of it. The idea is 'I don't think the market is going to go up that much, so I can get the 8% and run.' I can understand this argument, but I don't buy the argument."

His main objection is the payoff.

"You're capped on the upside at 8%. If you go down by more than 20% on the downside, you get no protection. I don't like either one of these things," he said.

"You're talking about full downside risk and capping your return. That's the opposite of what I'm looking for in a structured note. When I buy a structured note, I want to cap my downside and get a large upside potential."

The contingent protection offered by the note is a barrier, not a buffer, he noted. If the final fund price is less than 80% of the initial price, investors will lose 1% of principal for each 1% decrease in the price of the fund from the initial date, not from the buffer level.

While Kalscheur said he likes the credit quality of the issuer - Bank of Montreal is rated A+ by Standard & Poor's - the structure does not appeal to him.

"Maybe you have protection. But maybe you don't. I can't get excited over this," he said.

"I'm not a big fan of barriers. You have protection until you don't. As a financial planner, I can't plan for that. I'm trying to get rid of the black swan or the tail risk. My job is to try and eliminate things to worry about, not add things to worry about."

The notes will price Oct. 26 and settle Oct. 31.

BMO Capital Markets Corp. is the agent.

The Cusip number is 06366RHU2.

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