Bank of Montreal's absolute return notes tied to S&P have no cap but barrier disappoints

By Emma Trincal

New York, April 15 - Bank of Montreal's 0% contingent risk absolute return notes due April 29, 2015 linked to the S&P 500 index showed some attractive terms, but the barrier observable any day rather than just at maturity was seen as too risk by financial advisers.

A barrier event occurs if the index closes below 72.5% to 76.5% of its initial level on any trading day during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

The exact barrier level will be set at pricing. Sources assumed a hypothetical barrier of 75%.

If the index return is positive, the payout at maturity will be par plus the index gain.

If the index return is zero or negative and a barrier event has not occurred, the payout will be par plus the absolute value of the index return.

If the index return is zero or negative but a barrier event has occurred, investors will be fully exposed to any losses.

Among the positive aspects of the deal was the creditworthiness of the issuer. Bank of Montreal has an A+ rating from Standard & Poor's.

"The credit has to be good and if you're A+, you're very good, so it's definitely not a problem from that standpoint," said Michael Kalscheur, financial adviser with Castle Wealth Advisors.

Unlike most absolute return notes, this product had no cap on the upside, sources noted. It would have been a strong advantage with a more conservative downside protection, they said, adding that the downside barrier was not sufficiently protective due to its contingency and frequency of observation. Having a barrier versus a buffer was the first drawback. Also having a protection that could terminate on any day rather being monitored only at maturity represented the less appealing aspect of the structure, which, sources said, could not be offset by the uncapped upside.

Finally the short maturity, which investors often prefer to longer-dated maturities, was perceived as adding more risk with the "American-type" of barrier.

Gaming the decline

"It's more a game than an investment," said Carl Kunhardt, wealth adviser of Quest Capital Management.

"You have to think what is it that you're trying to create with this structured product?

"Are you trying to enhance returns? Hedge the risk? Get exposure to an otherwise very risky sector or asset class without taking the full risk of this sector or asset class?

"Whatever it is you're trying to accomplish, there's got to be an underlying objective."

Kunhardt said that investors were taking on too much risk for the potential return.

"If I want the uncapped upside, I can be long the S&P. That way I can get out any time," he said.

"I think this note is a bet. You're betting that during the two-year period, you could have a decline of the index but never a decline of more than 25%.

"I think this is for somebody who is too smart for their own good, someone who doesn't have to deal with clients.

"A broker may have a totally different perspective but as a wealth manager or a financial planner I wouldn't have any client interested in taking that bet."

For Kunhardt, despite a 25% contingent protection and the possibility of getting an absolute return if the barrier is never breached, investors in the notes were too complacent.

"If you sell that type of note, you're not paying attention to the downside and I suspect you don't think there is a downside. Even if 25% is a lot, it's a barrier, not a buffer and once you reach it, you no longer have any protection," he said.

Kalscheur agreed.

"You may get a positive return out of a decline of less than 25%. That's the benefit. The absolute return philosophy has a nice ring to it. You make money if it's up or down. But with this one, unlike other absolute return products I've seen, you don't have a buffer. You can lose everything if you breach that barrier," Kalscheur said.

For Kunhardt, having no cap on the upside was not consistent with the downside risk.

One time is enough

"Having no cap may seem attractive for someone who doesn't want to miss out on the upside. But if you worry about the upside, if that's why you don't want the cap, you should also worry about the downside. If you think the S&P 500 is volatile enough to give you a 40% return on the upside in two years then you should really expect the same type of downside. Volatility doesn't work only one way," he said.

"There is no maximum return but you're taking a 100% downside exposure once you hit the trigger and it only has to happen once.

Sources said that there was a real likelihood for the barrier event to happen.

"A barrier that can be breached at any point during two years is not that much downside protection," said Kunhardt.

"A 25% decline from the S&P would be about 375 points. How many times have we seen the S&P fall 375 points? Not often but it can happen," he said.

Kalscheur said that he was "leery" of the fact that the protection and the absolute return benefit of the notes could both be lost anytime.

"This any-day barrier is the deal-killer for me," said Kalscheur.

Term

The risk with this type of barrier was compounded by the relatively short duration of the notes, Kalscheur added.

"Over a short period of time, I'm even more concerned about the downside risk. The longer you go, the lower the highs and the higher the lows are. On a two-year note, I'm actually more worried about the size of my downside protection than I would be on a three- or four-year note, especially if this is not point-to-point. If it hits on any day, it knocks you out," he said.

"I would be willing to give up liquidity and invest for a longer period of time if I had a point-to-point barrier because I would have a little bit more time for these highs and lows to work out. I'd definitely be more comfortable in a three- or four-year product.

"When you invest in a structured note, you're taking on credit risk and you're giving up liquidity. You've got to get something in return. This one has less credit risk because we have a good credit. But you're still taking liquidity risk.

"I may be willing to cap my upside potential for better downside protection. I would definitely prefer a point-to-point barrier and a buffer even more. In general, I'm going to go with the more defensive positioning.

"I guess some investors may prefer having the uncapped upside. Others may like the shorter duration, it may be an incentive for them. I can see that. For me the downside protection would be the most important thing," he said.

Kunhardt said that he could have traded the cap for better downside protection.

"If it was a point-to-point barrier, I might give it more consideration. But the fact that one breach at any time can kill your protection is really not attractive," he said.

"I would have preferred a cap with a final barrier. I'm bullish on the index but I still think a 25% drop can happen anytime, so it's best to be a little more cautious."

In general, Kalscheur said that his clients are not necessarily receptive to absolute return notes.

"Absolute return notes are peculiar products," he said.

"You're betting that the market could go down and you would be happy if the market went down up to a point. I don't have any short seller in me. I think short-sellers just love it. But my clients are not like that. They're not interested in taking an inverse position and trying to benefit from that. They'd rather hold bonds or stay away from the market," he said.

The notes are expected to price April 24 and settle April 29.

BMO Capital Markets Corp. is the agent.

The Cusip number is 06366RNP6.

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