Bank of Montreal's 15.84% reverse exchangeables linked to National Oilwell Varco offer value

By Emma Trincal

New York, April 27 - Bank of Montreal's reverse exchangeable notes due Nov. 15, 2012 linked to the common stock of National Oilwell Varco Inc. offer a good income stream given the amount of risk taken, said Suzi Hampson, structured products analyst at Future Value Consultants.

The six-month notes are expected to carry a coupon of 15.84% per year. Interest will be payable monthly, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par unless National Oilwell Varco stock closes below the trigger price - 75% of the initial share price - during the life of the notes and the final share price is less than the initial share price, in which case the payout will be a number of shares of National Oilwell Varco stock equal to $1,000 divided by the initial share price or, at the issuer's option, a cash amount equal to the value of those shares.

The product has all the characteristics of the typical reverse convertible, said Hampson, with a fixed coupon earned regardless of the performance of the underlying asset, a downside barrier observable anytime, a relatively short duration and a single stock as the underlier.

Risk

But several factors give the notes an appealing risk/reward profile, she noted.

"First, the implied volatility of 33% doesn't seem that high given the nearly 16% coupon that's being offered," she said.

"Then you have a 75% barrier, which combined with that type of coupon, well above the risk-free rate, gives you an indication of the risk you might expect.

"But the riskmap suggests a lower risk level than average and certainly a lower risk level that what you might have anticipated."

Riskmap is a Future Value Consultants rating that measures the risk associated with a product on a scale of zero to 10. The higher the riskmap, the higher the risk of the product.

Compared with the average riskmap for reverse convertibles, 4.49, this product only shows a 3.06 riskmap.

"The 75% barrier is definitely a factor as it offers a good cushion compared to similar products," she said.

"The 8% coupon gives you a little bit of protection if the barrier was to be breached, although you have to consider what would happen in reality. If the stock was to hit the 75% threshold, the likelihood of seeing it creeping back up to the 92% price would be quite slim.

"However, say you breach the barrier and the stock finishes down 20%, you would end up only losing 12% as the coupon would offset 8% of the losses.

"So while your coupon is not really a buffer, it's better than a digital payout that's triggered when the underlying closes above a certain threshold. It's better because your coupon is not contingent upon any event. You will get it."

Riskmap is composed of a market riskmap and a credit riskmap.

The 2.71 market riskmap is below 3.97, the average riskmap for the same product type. This is due to a "not-so-high" implied volatility and the low barrier, she explained.

The product also shows a low credit riskmap of 0.35, which is less than 0.52, the average score for similar products.

"This doesn't so much reflect the issuer's credit risk. It's essentially a function of the short maturity. The credit spread of an issuer has an impact on longer maturities, for instance if you compare a five-year to a one-year," she said.

The average maturity of a reverse convertible, according to Future Value Consultants' most recent ranking tables, is one year rather than six months.

The number of one-year reverse convertible rated last month was 92 versus 66 six-month products and 33 with a three-month tenor, she said.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The low-volatility assumption is the most favorable for reverse convertibles, she explained.

"A reverse convertible will pay its maximum return as long as it does not breach the barrier. It doesn't matter if your stock finishes up or down. It just can't hit the barrier, which is why the ideal scenario is low volatility," she said.

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the five key assumptions.

When using the neutral assumption, which is a risk-free growth scenario, the notes show an 80.4% chance of receiving the full return of 15.84% per annum.

When switching to a low-volatility market assumption, this probability rises to 85.4%.

On the loss side, the odds of losing more than 15% of principal are 16% in the cash scenario. The probability is 13.2% in the low-volatility scenario.

The return score of this product is 7.21 against 6.10 for comparative products.

"The barrier combined with the coupon gives you a very good return score. They are paying a high coupon considering the risk you're taking," she said.

The product obtained another good rating with its price score.

With its price score, Future Value Consultants measures on a scale of zero to 10 the market value of the underlying components of the product as a percentage of the initial investment.

The score gives an estimate of the fees taken per annum. The higher the score, the lower the fees and the greater value offered to the investor.

Price, overall

This product has an 8.87 price score, well above the 6.62 average for the same product type.

"It's very high. This note scored well throughout all the other ratings, and you just have a price score agreeing with everything else," she said.

"Given the risk and the coupon, they had to spend a lot on the options. As an investor you're getting some good value on these options. The income stream that they pay is attractive given the risk."

Hampson said that one advantage of assessing the value of a reverse convertible is that the embedded options used for the structure are relatively simple.

"With a reverse convertible, it's pretty transparent. You really have two things going on: the income stream and the barrier. You also use vanilla options.

"You can see easily what's going on. A lot of the time, a low riskmap, a high return and a high price score are all in line," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

The overall score of the notes is 8.04. It compares favorably to the 6.36 average score for similar products.

"This is scoring very well all across the board," she said.

"This note is for investors looking for fixed income and who presumably have a view on the stock. Investors should have a reason to buy this product and not base their decision solely on the coupon. It wouldn't be wise," she said.

"Investing in this type of product suggests that you expect volatility to decrease as you just want to limit the chances of hitting the barrier. It's a volatility play."

The notes (Cusip: 06366YAS9) are expected to price May 10 and settle May 15.

BMO Capital Markets Corp. is the agent.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.