BMO’s $1.95 million leveraged buffered notes on iShares MSCI Mexico offer unusual country bet

By Emma Trincal

New York, July 31 – Bank of Montreal’s $1.95 million of 0% market-linked securities with leveraged capped buffered notes due July 29, 2022 linked to the iShares MSCI Mexico ETF offer exposure to a rarely used underlying in a note, according to data compiled by Prospect News.

The iShares MSCI Mexico ETF (including its capped version) has been employed as sole underlier only in nine offerings totaling $77 million, which includes BMO’s recent deal.

HSBC USA Inc., UBS AG, London Branch and JPMorgan, along with now gone Deutsche Bank AG, London Branch, have issued notes tied to this ETF, according to the data going back to 2004. It was the first time BMO used this fund as a single underlying in a registered note.

The ETF was used before in other trades but as a component of various emerging market baskets, including selected Asian emerging market countries. It was often paired with the iShares MSCI Brazil fund.

The BMO notes pay at maturity par plus 1.5 times any gain in the fund, up to a maximum return of 34%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the shares fall by up to 7.5% and will lose 1% for every 1% decline beyond 7.5%.

Value

The notes offer an interesting value play, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

“This ETF is still trading at low levels compared to its price in the spring. It was at $24.94 in early April, which was its lowest since the middle of 2009,” he said.

Since the spring, like most equity markets, the share price has regained momentum.

“But it’s still cheap,” he said.

The ETF traded at $33.00 in the mid-morning session on Friday, or about 31% of its 52-week high of Jan. 22.

Meanwhile the U.S. market has climbed nearly 50% from its low of March. The benchmark is now 4% away from its all-time high of Feb. 19.

“Mexico is much cheaper than the U.S.,” he said.

Reversal

“Of course, this deal would have been much better if it had priced four months ago. But it’s still OK.”

The underlying closed at $32.76 on July 24 when the notes priced, setting the 92.5% buffer level at $30.30.

There is still downside risk regarding the entry level, he noted.

Assessing the value of the 7.5% buffer required one to consider the relative low price of the fund from its highs while being mindful about the speed of the recovery rally, which raises the odds of a reversal.

“After a short-term rebound, markets tend to give up,” he said.

“However, the buffer level of $30 a share is approximately half-way between last spring’s low and today’s price.

From a simple valuation standpoint without considering the investment timeframe, the deal appeared to be “reasonable,” he said.

Emerging market play

Of course, investing in Latin America and emerging markets is risky, he noted.

“You always have the unknown. Mexico has a lot of problems. But some of them are not true problems,” he said.

Some investors for instance are often “overly concerned” about currency fluctuations, he said.

“Since those are politically driven it seems like a less stable situation.”

But compared to many emerging markets in general, the level of prosperity in Mexico is fairly high, he said.

“It may come as a surprise but earnings growth in Mexico through the last 40 years is slightly higher than in the U.S.

“This is a market that can drop sharply. But when they have a recession, they tend to have a dynamic recovery in the short term.

“If you look at Brazil, Chili and even Poland, you’ll see similar patterns.”

Cheap labor

Kaplan pointed to an economic factor, which contrarians could see as bullish for Mexican stocks.

“Those currency fluctuations tend to scare away U.S. investors. But it’s the weakness of the Mexican peso that drives profit growth in this country. In a way, it helps explain why such growth is more stable there than it is in the U.S.,” he said.

He offered more detailed explanations.

“While the Mexican peso has been gaining ground lately, it remains low against the U.S. dollar,” he said.

“That in turns helps Mexican companies maintain and even grow their profit margins.

“They pay their employees in national currency while selling most of their goods in U.S. dollars.

“For the same work they pay their workforce less in dollar terms since wages are denominated in pesos.

This has an impact on Mexican consumers when they want to buy international goods such as U.S.-made technology products or even gasoline but not when they buy food, clothing, or any local product, he noted.

“Mexico has depressed labor compensation levels but strong profits, which supports a relatively prosperous economy,” he said.

“It may be why Mexican equity markets tend to rebound quickly.”

Two-year term

Kaplan however said the structure of the notes had some shortcomings, starting with the duration.

“The only negative is timing,” he said.

Because Mexico has rebounded quickly, there is potential downside ahead, he explained.

“The risk is exacerbated by the odds of a U.S. recession, which of course would impact Mexico, one of our largest trading partners,” he said.

“Even if Mexico’s economy is relatively healthy, any U.S. recession will exert a significant downward pressure.

“Two years is not the best tenor in my opinion. Within two years, the U.S. is likely to be in a recession and it’s probably going to be a serious one,” he said.

“I would rather have a five- or even four-year note. A one-year would still be OK I guess, but not two.”

Risk-adjusted return

Kaplan examined the relationship between the cap and the buffer.

“You always want to have a higher cap or no cap at all. But this one is not totally out of line,” he said.

“I’d rather have a more generous buffer than 7.5%. I know it’s hard to get both a higher cap and a bigger buffer, so given the choice I’d go for a better buffer.”

Kaplan was not convinced that the terms offered a better alternative than buying the fund itself.

“I’d rather invest directly and be long the ETF. I would not be giving up the dividends,” he said.

The iShares MSCI Mexico fund yields 1.75%.

“The entry price is relatively fine. But with a two-year maturity, a series of risks emerge during that period. It would require more protection. If I had the choice, I’d rather be long,” he said.

Wells Fargo Securities, LLC is the agent.

The notes settled on July 29.

The Cusip number is 06367WZ71.

The fee is 2.66%.

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