Bank of Montreal’s bullish leveraged notes tied to S&P to outperform market if growth is slow

By Emma Trincal

New York, Feb. 20 – Bank of Montreal’s 0% bullish enhanced return notes due Aug. 25, 2016 linked to the S&P 500 index can beat the performance of an equivalent index fund but only in a moderately bullish market environment, and the caveats are full downside exposure and limited upside, said Tim Vile, structured products analyst at Future Value Consultants.

The payout at maturity will be par plus triple any index gain, up to a maximum return of 18.5% to 20.5% that will be set at pricing. Investors will be exposed to any losses from the initial price, according to a 424B2 filing with the Securities and Exchange Commission.

The three-times leverage factor enables noteholders to outperform the underlying index in a slow-growth market, Vile said.

The research firm chose the mid-point of the range of caps as the hypothetical cap to run its scores and generate its report.

Based on a hypothetical cap of 19.5%, the product delivers a high annualized maximum return of 12.6% with compounding. To get to this point, the S&P 500 index only needs to rise at a pace of 4.3% a year.

“It’s a generous upside in a sluggish market. However, if the market is more bullish, investors could be capped and therefore underperform the benchmark,” he said.

“These notes are not designed for someone who is very bullish. You would be capped out if the market was up a lot.

“On the other hand, it’s not for bears either. There is not downside protection at all, so investors need to be confident enough that the market will go up, not down.”

Riskmap

Future Value Consultants measures the risk, or “riskmap,” of a product by adding two risk components – the market riskmap and the credit riskmap. Each score is established on a scale of zero to 10 with 10 representing the maximum amount of risk.

The product is scored against its peers, which in this case are other leveraged return notes.

At 3.16, the market riskmap of the notes is higher than the average score for the product type, which is 2.86, the report showed.

“The S&P 500 index with an implied volatility of about 20 is less volatile than many other underlying assets used in similar products. We’re comparing these notes with a variety of leveraged products tied to potentially more volatile indexes or funds,” he said.

“What brings the score down despite the relatively low volatility of the underlying is that you can potentially lose your entire investment. The lack of any barrier or buffer increases the risk.”

The credit risk of 0.18, however, is much below the 0.54 average for the category.

He mentioned two factors. First, the creditworthiness of the issuer and second, the relatively short duration compared to the average leveraged note.

Short-term notes are less sensitive to changes in credit swap spreads, and the odds of a negative credit event are lower, which reduces the amount of credit risk, he explained.

In addition, the issuer’s credit rating is strong.

Bank of Montreal is rated A+ by Standard & Poor’s. Canadian banks tend to have good ratings with Royal Bank of Canada rated AA- by S&P and Bank of Nova Scotia, A+.

When adding the two risk components, the riskmap ends up slightly lower than average at 3.34 versus 3.40 respectively, according to the report.

“The low credit riskmap offsets the higher-than-average market risk, which gives us a decent riskmap compared to similar notes,” he said.

Future Value Consultants also scores the average of “all products,” a category that encompasses all structured notes recently rated regardless of their structure type. The average riskmap for the wider category is 3.51, making the notes look even better in comparison, he noted.

“Again, this has a lot to do with the low credit risk and the low volatility of the index used in the notes. Both offset the risk associated with the lack of downside protection,” he said.

Return score

Future Value Consultants measures the risk-adjusted return of each product with its return score.

The rating is calculated using five key market assumptions: neutral, bullish, bearish, high volatility and low volatility. The best of the five scenarios is selected to measure the risk-adjusted return on a scale of zero to 10. The assumption used in the model is bullish.

The return score of 7.67 is “about average” compared to the same structure category averaging 7.63, he said.

“This is mostly due to the cap. As we use the bullish scenario, the potential return is limited unlike other leveraged notes which are uncapped or capped at a higher level for a similar amount of risk. Despite the leverage factor of three, the cap will limit how much investors can make,” he said.

“Notes always score better when there is no limit on the upside, especially with longer-dated products.

“This note is for mildly bullish investors. A more bullish investor would probably choose to leverage down a bit an increase the cap.

“As the score measures the risk-adjusted return, the high market riskmap brings down the return score as well.”

Price, overall scores

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10.

The notes received a price score of 8.56, compared with 7.37 for the average leveraged return product, according to the report.

“The return score is only average, but the price score is very good, more than one point over average. This indicates that the issuer has spent a good amount of money on the assets, bringing more value to the investment,” he said.

The estimated initial value of the notes is $981 per $1,000 of principal amount, according to the prospectus.

The price score estimates the fees taken per annum, according to Future Value Consultants’ methodology. The higher the score, the lower the fees and the greater the value offered to the investor.

“Because of the good pricing, the product has a very good overall score compared to similar products,” he said.

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The overall score is 8.11 for the notes. The average for the same product type is 7.50, according to the report.

The notes (Cusip: 06366RB61) were scheduled to price Friday and will settle on Wednesday.

BMO Capital Markets Corp. is the agent.

© 2015 Prospect News.
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