Bank of Montreal’s notes tied to iShares MSCI EAFE ETF offer international, uncapped exposure

By Emma Trincal

New York, Dec. 7 – Bank of Montreal’s buffered bullish enhanced return notes due Dec. 31, 2020 linked to the iShares MSCI EAFE exchange-traded fund give bullish investors seeking exposure to developed market countries full upside and leveraged exposure as well as buffered protection. The trade-off is a five-year duration and some downside leverage beyond the buffer.

While advisers agreed the terms are attractive, one said the buffer type would not be an option for him.

The payout at maturity will be par plus 137% of any fund gain, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to 15% and will lose 1.1765% for each 1% decline beyond 15%.

For instance, if the fund finishes down 20%, investors will lose 5% times the 1.1765 multiple, or 5.88%.

If the product had been structured with a standard buffer of the same amount, a 20% decline would result in a 5% loss instead, which is a small difference.

However, the gap increases, making the leveraged buffer increasingly unattractive as the fund further declines to a point where investors may lose 100% of their investment, according to the prospectus.

Terms

“I wouldn’t do it,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“On the baseline, it’s an attractive note. The EAFE is a well-known index. It has a large European stock weighting. But if you’re going to have non-U.S. assets, you’ve got to be in Europe. Non-U.S. equity has a place in the core portfolio. It’s not an allocation that’s ever going to go to zero.

“It’s a nice buffer size. Great issuer. At first blush everything looks good. Even the five-year term is fine.

“But if I take a look at what’s available out there for a five-year, I’m pretty sure I can get almost the same without the leverage on the downside. When you go as far as five years, getting uncapped leverage is not so difficult. The advantage of extending the maturity is precisely to get rid of the cap while maintaining the leverage, so that’s not even an issue.

“If I have a comparable note, I am not going to mess with the downside leverage because we don’t know if the market will be up in five years, so why would I take the risk?”

Kunhardt said he would probably be able to find a similar structure with a non-geared buffer with perhaps some minor differences.

“What am I gaining here? Yes, Bank of Montreal has a good credit. But banks issuing those notes are not going out of business. As long as the first letter starts with an A, I don’t really care.”

Bank of Montreal is rated A+ by Standard& Poor’s and Aa3 by Moody’s.

Issuer, structure

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he likes the protection combined with upside leverage and no cap.

“Bank of Montreal is a very strong bank. We wouldn’t have a problem getting behind them on a note,” Kalscheur said.

“The structure is very straightforward, the index is well-known and well-diversified, so it meets our criteria for simplicity, including the fact that it starts and ends on Dec. 31. That happens to be neat.”

He noted that the MSCI EAFE index has underperformed the S&P 500 index for several years.

In the past five years, the S&P 500 gained nearly 70% while the MSCI EAFE index rose by only 5.5%.

Underlying

“It would be a good bet for contrarian investors,” he said.

The duration and the underlying are also satisfactory.

“The five-year tenor is good for us. We try to preach long-term investing to our clients,” he added.

“We use the MSCI EAFE index as the benchmark for our international managers with a broad mandate. I’d rather use the EAFE than the Euro Stoxx because it’s a little bit more broad-based.”

European stocks make for more than 60% of the index, but the top country allocation is Japan with 23%. Australia represents 6.65% and Hong Kong 3%.

“Normally I use active managers for my international allocation, but the terms of this note are so attractive, I would consider it,” he said.

“I’m looking at the 25 basis points fee on the prospectus on a five-year and I’m wondering if it’s real. If this is not a typo, it’s phenomenal. The terms in general for this note are so good, I’m wondering if they are correct.”

Outperformance

“Not only do you have a decent amount of leverage, almost 1.4 times, but there is no cap. You give up the dividends – the yield is 2.8% – but at some point, the leverage offsets that. You break even and you outperform the index,” he said.

“Then you have a 15% buffer. It’s not a barrier but a buffer. What it means is that you’re going to outperform the index on the downside.

“In addition, you can take advantage of the geared buffer to get tax benefits. That’s because in theory your entire principal is at risk. So your gains and losses are going to be treated as capital gains or losses, not as income.

“The tax benefits by far are going to outweigh the little extra loss you incur with the downside gearing. I can put it in a taxable account and take advantage of it. Someone in New York with a 50% marginal tax bracket will be happy to get that type of benefit.

“The protection remains strong. If we have another 2008, if the market is down 35%, you’re going to lose 23%, not 35%. You’ll actually beat the market by 12%. Nobody is going to complain about it.

“You win in two out of three scenarios. The bad scenario so to speak is if the index doesn’t move much. But other than that, if it’s way up, you win because of the leveraged and uncapped upside. If it’s down, you win because of the buffer. I really like it.”

BMO Capital Markets Corp. is the agent.

The notes will price on Dec. 28 and settle on Dec. 31.

The Cusip number is 06366R5R2.

© 2015 Prospect News.
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