Bank of Montreal's 3% bullish notes linked to real estate fund offer coupon plus participation

By Emma Trincal

New York, Sept. 6 - Bank of Montreal's 3% buffered bullish enhanced return notes due Sept. 17, 2014 linked to the iShares Dow Jones U.S. Real Estate index fund are designed for moderately bullish investors looking to combine yield and participation in the real estate investment trust sector, sources said.

Interest is payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

If the fund return is positive, the payout at maturity will be par plus the return, subject to a maximum of 11.5% to 14.5% that 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%.

The underlying fund tracks the Dow Jones U.S. Real Estate index, a subset of the Dow Jones U.S. index.

This index measures the performance of the real estate sector of the U.S. securities market and is comprised primarily of REITs. The dividend yield of the exchange-traded fund is 3.4% according to iShares' website.

Steve Doucette, financial adviser at Proctor Financial, said that he likes the product for the downside protection and as an additional source of yield.

Extra cushion

"I would have to do some due diligence on this index, but it looks really nice," he said.

"You have a 16% protection if you take into account the coupon on top of the 10% buffer.

"You also have some participation in the index, and if you add the 3% interest, your maximum upside is 9% to 10% a year, which is not a bad rate."

The lower end of the cap on the two-year term is 11.5%, which would represent a 5.75% maximum return per year, he reasoned. The higher end, a 14.5% cap, is 7.25% a year. By adding the 3% annualized interest rate, investors, in the best-case scenario, can generate a total return anywhere between 8.75% and 10.25% depending on the final cap.

"Of course, there is still some risk as some of these REITs have been slaughtered from a price perspective," Doucette said.

"REITs are a lagging indicator. It should pick up more when the economy moves around.

"If you're a bull on the economy, the cap is not such a great thing. But if you're looking for income replacement, it's a reasonable deal.

"You have 16% protection, and you might pick some income plus an extra 6% to 7% payout from the underlying."

Doucette said that the product may be more appropriate for more conservative investors as opposed to equity investors.

"REITs is really an equity asset class, but the note should be used as a fixed-income replacement. You keep a decent coupon with a decent protection on the downside. It's a nice buffer in the event that the index goes down a lot," he said

Bullish but cautious

Matt Medeiros, president and chief executive officer at the Institute for Wealth Management, said that he is bullish on the sector but not convinced that the downside protection is sufficient or that the risk/reward profile is appealing.

As stated by the prospectus, investors can still lose 90% of their principal, he noted.

"I like the REITs sector as a good proxy for yield. It has been a very nice allocation for us from an appreciation perspective this year," Medeiros said.

The fund is up 17% so far this year. It gained 21% in the past year but collapsed in 2008 when the real estate bubble burst, losing 40% during that time.

"The [price-per-earnings] of this sector is relatively high," said Medeiros.

"I am a little concerned that the potential fluctuations in price could exceed the buffer on this particular note.

"I like the asset class, and it looks like the terms of this product are reasonable. But with this particular underlying, I would prefer to see a little bit more of a buffer."

Medeiros said that he does not include the 3% coupon in the protective cushion because the fixed interest is part of the return. Instead, he only considered the 10% buffer.

"That 10% buffer could be penetrated in a short period of time," he said.

This does not stop Medeiros from remaining bullish on the sector as REITs, he said, offer new opportunities for gains after a steep decline in the aftermath of the financial crisis of 2007-2009.

He drew a distinction between REITs and residential real estate.

"When you think REITs, think about strip malls. Most of those properties are commercial real estate, and their financing does not really depend so much on mortgage rates," he said.

"But they do benefit from a real estate sector that's still depressed. REIT firms have an opportunity to acquire property at deeply discounted prices. They can get access to capital via private investors, endowments or pension funds. If they are publicly traded, they have the capital markets too. They can deploy this capital to buy properties at bargain prices. Meanwhile, occupancy rates have been rising. They can more easily rent offices or apartments than before. The rental market is increasing faster than the home ownership market. All of these factors are positive for the sector."

Medeiros said that he probably would not choose the notes over a direct investment in the ETF.

For one thing, he said, the 3% coupon on the notes is nearly 0.5% less than the dividend yield a fund investor would collect.

Another difference is that the ETF has no upside limit while the notes offer a return limited to the cap and the interest payment.

"I know that there is the 10% buffer. But to persuade me to buy the note versus buying the ETF itself, which has no cap on the underlying, no credit exposure and is liquid, I would need to get a little bit more yield. I would also need more of a buffer as a compensation for the illiquidity associated with the note," he said.

The notes (Cusip: 06366RHJ7) are expected to price Sept. 12 and settle Sept. 17.

BMO Capital Markets Corp. is the agent.

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