Bank of Montreal to price two notes tied to Russell ETF - one for growth, the other for yield

By Emma Trincal

New York, Feb. 13 - Bank of Montreal is planning a pair of one-year products tied to the iShares Russell 2000 index fund but designed for two different types of investors and investment objectives, one targeting bullish investors and the other income-seekers, sources said.

Both notes, with a Feb. 28, 2013 maturity, will price on Feb. 24.

The respective structures are also very distinct, sources said.

While the growth product offers leverage, a cap and a final-day buffer, the other one is an autocallable reverse convertible with a downside barrier, which can be breached any day.

"These two notes serve totally different purposes," said R. Scott Cramer, president at Cramer & Rauchegger, Inc.

"One is a growth story, the other an income story," he said.

Growth

Bank of Montreal plans to price 0% buffered bullish enhanced return notes due Feb. 28, 2013 linked to the iShares Russell 2000 index fund.

This product is the leveraged, capped buffered note.

The payout at maturity will be par plus 150% of any gain in the fund, up to a maximum return of 10% to 12%, according to a 424B2 filing with the Securities and Exchange Commission.

The exact maximum return will be set at pricing.

Investors will receive par if the fund falls by up to 10% and will be exposed to any decline beyond 10%.

"This note is for someone looking for growth and willing to pay for it, someone who is ready to give up some of the upside and who doesn't think the Russell will grow too much," Cramer said.

"It has some downside protection and a reasonable upside," he added.

"Assuming the maximum return is 12%, the leverage factor would let investors hit the 12% cap with the Russell only growing by 8% for the fund."

The iShares Russell 2000 exchange-traded fund is up 11.75% year to date.

A more bullish investor may not be interested in this deal, said Carl Kunhardt, wealth advisor at Quest Capital Management.

"I'm not intrigued by this one because I think the cap is too low," he said.

"My expectation one year from now for this index is in the 8% to 9% range.

"But if I am going to take some downside risk - and to me, being locked in for one year with only a 10% buffer represents some level of downside risk - then I don't want to be capped at my expectation. I want more.

"What if the Russell is up 15%?" he said.

Income

The second product was Bank of Montreal's 7% to 10% autocallable reverse exchangeable notes due Feb. 28, 2013 linked to the iShares Russell 2000 index fund, according to a 424B2 filing with the SEC.

Interest will be payable quarterly. The exact coupon will be set at pricing.

On four quarterly call dates, the notes can be automatically called at par if the price of the fund at that time is flat or higher than its initial level. The call dates will be May 25, Aug. 28, 2012, Nov. 27, 2012 and Feb. 25, 2013.

If the notes are not called, the payout at maturity will be par unless iShares Russell shares ever close below the trigger price - 70% of the initial share price - and finish below the initial share price, in which case the payout will be a number of shares of the fund equal to $1,000 divided by the initial share price or, at the issuer's option, the cash equivalent.

Cramer said that the value of the callable reverse convertible product was more difficult to assess because it would really depend on what the investor would want to accomplish.

"This is definitely an income story. But I can only see two main reasons to invest in this.

"Either it's a very short-term investment. You want the call after three months and redeploy your capital elsewhere. You've made 2.5% for the quarter.

"Or you hope to stay invested for the whole year so that you can get your full 10% income. In that case you don't want the call.

"The first reason would not be my motivation. Maybe for the market timer who thinks the Russell will be up for the short term, this would be a good short-term investment. But I don't believe in market timing.

"The second motivation - getting the maximum return and staying invested until maturity - requires that you're slightly bearish on the Russell.

"You don't want the index to stay the same or go up, because you don't want the early exit.

"Instead you're betting down a little bit. But you don't want it to fall by more than 30%.

"If you're bearish, then it's a great investment.

"This second approach to me is the only one that makes sense if you have that type of market view, if you're not bullish but not too bearish. If you truly want your full 10% coupon, you need the Russell to stay down but in a range.

"It also makes sense in terms of risk. You have a 30% downside protection. Since you get paid a 10% coupon regardless in any event, you break even if the index falls by 40%. I think it's safe enough," he said.

Complexity

Kunhardt said that he would not show the autocallable note to any of his clients because of the complexity of the structure.

"My first criteria before I show any product to a client is simplicity. I have to be able to explain it to them in 15 to 30 seconds without their eyes glazing over. It could be the greatest investment in the world, if it takes more time than that for them to understand the main idea, they're just not going to do it," he said.

Among some of the elements of the deal, he said were too complex to be understood quickly, was the fact that different observation dates applied for different events.

"You have to look at each quarter to see if you're going to get called. That's one piece of the puzzle.

"Then you have this barrier that can be breached any day.

"Finally you have the point to point payout. Are you getting par at maturity? Are you getting less? It will depend.

"Has the barrier been breached? Is your index down at maturity?

"This is the type of explanation you have to give: and what if this happens? What happens there if this is happening instead of that? And then? What could possibly happen in this case?

"This is the type of products I wouldn't even show my clients. They don't want it. They don't like the complexity. You have many moving parts.

"Not to mention the barrier. I'm not too keen on barriers. I'd much rather have a buffer," he said.

BMO Capital Markets Corp. is the agent for both notes.

The Cusip for the leveraged product is 06366Q2T3.

The Cusip for the reverse exchangeable note is 06366Q2S5.

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