Bank of Montreal’s absolute return notes tied to Euro Stoxx ETF show fair payout, lengthy term

By Emma Trincal

New York, July 3 – Bank of Montreal’s 0% contingent risk absolute return notes due July 31, 2020 linked to the SPDR Euro Stoxx 50 exchange-traded fund offer an enticing payout as well as exposure to a popular asset class, sources said.

But the longer tenor, understood as the trade-off to obtain the attractive structure, is not an option for some buysiders.

If the ETF return is positive, the payout at maturity will be par plus 111% of the ETF return, according to a 424B2 filing with the Securities and Exchange Commission.

If the ETF return is less than or equal to zero but not less than negative 40%, the payout will be par plus the absolute value of the ETF return.

If the ETF return is less than negative 40%, investors will be fully exposed to the ETF's decline.

Twin win

The structure, alternatively called a “twin win” or a “dual directional” note, gives investors more than the protection usually provided by a barrier, explained Steven Foldes, president and chief executive of Foldes Financial Management LLC.

If the underlying asset declines without breaching the barrier, investors will get more than par – they will be exposed to a positive participation in the downside.

“Twin wins are a very interesting concept. You can win on the way up with respect to the leverage and on the way down. The possibility of making money from a 40% decline is exciting. And the fact that the upside is both leveraged and uncapped is very appealing too,” he said.

“What really gives us a hard time here is the six-year [tenor].

“I love the idea of a twin win. I like the asset class exposure. We even think that over a six-year period, there would be for the market enough time to recover should we see a correction. It’s unlikely that a market drop six years from now would take you below the barrier.

“It’s not the barrier that’s a problem. A 40% level is very good. And we certainly don’t have a problem with the uncapped leverage, which we always strive to get in a structured note.

“The problem is the term. Unfortunately, from the point of view of our clients, we’re not going that far.”

Too long

Foldes acknowledged that the combination of upside leverage, no cap and an absolute return payout on a barrier as deep as 40% is very attractive and that the longer term is part of the trade-off.

“I know that banks are increasingly extending the maturities as a way to make structures more attractive, but six years for us is a non-starter,” he said.

“Two years is what we want. Three years is a stretch. We’ve done it, but it’s a bit long. But we can’t do six years.

“Even if they modified the structure, the mere fact that it’s a six-year would be a killer for us, even if they gave us more leverage, for instance 1.5 instead of 1.11. Our investors just would not want to go that long.”

The only way Foldes would consider investing in this product would be through a reverse inquiry, asking the issuer what type of absolute return structure could be built around the same underlying but on a much shorter term.

“We would have to talk to the issuer and ask them what they could offer on a two-year or a three-year for a twin win,” he said.

“But I’m afraid that they would go back to us with a cap or a much less attractive barrier level.

“If they could offer something on a three-year, I may be in a better position to look at different options, including a smaller barrier. We would have to see what they can come up with.”

Euro bull

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said that he is bullish on the underlying asset class and that the structure is attractive, but the longer maturity would require more due diligence in order for him to be “comfortable” with the issuer.

“I like the underlying fund, the valuation of the European market. From an underlying perspective, it’s attractive,” he said.

“But because of the longer term, I would have to do more research on Bank of Montreal in order to build a comfort level. It’s not just about the credit spreads or the ratings; we need to do additional research on the bank. I would have to talk to them, get to know who they are. I haven’t looked at notes further than five years in the past. It doesn’t mean that I wouldn’t. But we have never done business with Bank of Montreal before, so we would need to know more about them, simply because six-year is a relatively long maturity.”

Medeiros said that the structure offers a lot of benefits.

“It’s a very interesting deal,” he said.

“I like the fact that it has no cap. The perspective of turning a negative return into a gain insofar as it doesn’t break the barrier is appealing.”

Medeiros said he is bullish on European equity.

“The Euro Stoxx is very compelling. As the S&P continues to appreciate, valuations on U.S. stocks are getting higher and investors are looking for new places to take risk. Europe is a good opportunity right now. The S&P has outperformed European stocks by pretty significant margins, and as a result, investors are starting to focus on growth opportunities with lower PEs, which they can find in the euro zone,” he said.

U.S. sister deal

Separately, Bank of Montreal announced a deal that is very similar but linked to a fund tracking a U.S. equity benchmark.

Bank of Montreal plans to price 0% contingent risk absolute return notes due July 31, 2020 linked to the SPDR Dow Jones industrial average ETF, according to a 424B2 filing with the SEC.

The upside participation rate is 105% versus 111% with the other deal. Both structures offer uncapped upside.

The barrier percentage for the U.S. version is 30% instead of 40% with the absolute return benefits triggered under the same terms: as long as the underlier declines by 30% or less, investors have the benefit of the absolute return. Otherwise, they are fully exposed to the fund’s decline.

The notes linked to the Euro Stoxx 50 ETF (Cusip: 06366RUU7) and to the Dow ETF (Cusip: 06366RUV5) are both expected to price July 28 and settle July 31.

BMO Capital Markets Corp. is the agent.

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