BMO’s leveraged notes tied to Vanguard REIT ETF show good terms but no fat yield in return

By Emma Trincal

New York, Nov. 14 – Bank of Montreal’s 0% buffered bullish enhanced return notes due Dec. 17, 2018 linked to the Vanguard REIT exchange-traded fund offer almost the best of all worlds, a financial adviser said, citing short tenor, leverage, “high cap” and buffer. However, investors in return have to give up an exceptionally high yield to access the benefits of the structure.

The payout at maturity will be par plus 200% of any ETF gain, up to a maximum redemption amount of $1,132 per $1,000 principal amount, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the ETF falls by up to 10% and will lose 1.1111% for every 1% that it may decline beyond 10%.

“This is really interesting. They give you a high enough cap with the leverage on a 13-month product plus a buffer. I find those terms very competitive,” said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

Basics

To begin his analysis, Kalscheur said he was comfortable with the credit of the issuer as he tends to be with most Canadian banks.

Bank of Montreal is rated A+ by S&P Global Ratings, which also made him confident about his credit risk exposure.

The underlying, he noted, is not a broad-based index like the S&P 500 or the Dow Jones industrial average. But the index is known as one of the main benchmarks for the real estate sector of the U.S. equity market.

The Vanguard REIT ETF tracks the performance of the MSCI U.S. REIT index.

“We have a dedicated real estate allocation in our portfolio, and we benchmark our active or even passive real estate holdings based on this index,” he said.

Good terms

But more than anything else, Kalscheur liked the terms of the notes.

“You have this leverage, which is really good, especially if the index does not go up very much,” he said.

The underlying ETF performance has been lackluster. The fund is up only 2.5% this year and gained 8.5% last year. In 2015, its growth was only 2.4%. But in good years the ETF can skyrocket and outperform the overall market as it did in 2014 when it finished the year up 30.6%, which was more than twice the return of the S&P 500 index.

Headwinds

Kalscheur is not particularly bullish on the asset class.

“Overall this index has not performed very well. It’s fair to say it has gone nowhere,” he said.

The perspective of higher rates has not helped the sector, he noted.

“A company like Simon [Property] is very debt-heavy, and if rates go up, it’s going to be a definite headwind for them.”

Simon Property Group is the first holding in the index with a 5.77% weighting.

Another factor weighing against the sector, he said, was the preeminence of retail REITs in the index. Those, especially malls face the harsh competition of Amazon.com, Inc., he noted.

Cap

The cap, which is about 12.15% a year on a compounded basis, was “high enough,” he said, and probably easy to achieve given the double upside exposure.

“If you tell me you’re getting 7% a year, I would say: no thanks. But anytime you’re getting a double-digit in a structured, it’s good.

“This one is almost in the teens on an annual basis. That’s very competitive.

“My gut tells me you’re not going to leave a bunch of money on the table. You’re going to have an opportunity to meet or exceed the index return,” he said.

Fat yield

There was on caveat, however. Noteholders do not receive dividend distributions. This particular ETF happens to pay a high dividend yield of 4.8%.

“That’s a big dividend yield and certainly that’s the downside of the product,” he said.

“The leverage really helps you weather the huge yield hit.”

Foregoing dividends was still a reasonable tradeoff partly because of the buffer.

“I can’t really imagine how they could price this high cap, the leverage and the buffer on something so short. You could never do that with the S&P,” he said.

Speaking of the buffer, he said the “gearing” did not concern him.

“I’m just amazed you have a buffer at all.

“There is a lot to like about this offering.”

Big impact

Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, held a different view. To him, the structure did not compensate investors enough for giving up the yield.

“It has a big impact. People invest in this sector precisely for the yield,” he said.

Kaplan compared the return of the notes, which is double the price return up to the cap, with the total return of the underlying.

“It’s only fair to compare if you need to decide whether you want to buy the ETF or this product,” he said.

Dividend versus leverage

The notes will only outperform the index in a narrow range. This range would be between the dividend rate and a price level defined as the cap minus the dividend, he said.

The dividend yield is 5.2% over the 13-month period.

This would mean a 5.20% to 8% range in which the notes would outperform the underlying, he said.

“It’s a very narrow range of price increase,” he added.

In addition, the price return at which the notes outperform at best only brings a marginal percentage of alpha, he noted.

The notes do best when investors receive the 13.2% cap, which represents a 6.6% price return. At that price level, the total return of the index would be 11.8%, he noted.

“If you compare those two returns, 13.2% with the notes and 11.8% with the index, you only beat the index by 1.4% and that’s the best you can do,” he said.

Liquidity

For Kaplan, the tradeoff was not favorable to investors.

“I don’t think you’re getting compensated enough for giving up that type of yield,” he said.

“You’re not compensated enough either for the limited liquidity.

“Thirteen months may not seem like a long time, but if we hit a bear market – and I believe we’re due for one very soon – you’re increasing your chances of something going wrong.”

BMO Capital Markets Corp. is the agent.

The notes will settle on Friday.

The Cusip number is 06367TQ45.

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