BMO’s leveraged capped notes with barrier on Dow designed for range bound market, advisers say

By Emma Trincal

New York, Aug. 18 – Bank of Montreal’s 0% market-linked securities with leveraged upside participation to a cap and contingent downside due Sept. 6, 2022 linked to the Dow Jones industrial average offer leveraged exposure on a single index, uncapped return over a two-year investment period as well as a barrier on the downside, features usually appreciated by advisers.

But both the cap level and the barrier were of concern based on the bullish or conservative view one may hold, leading advisers to conclude that the notes were mainly designed for a sideways market.

If the index gains or finishes flat, the payout at maturity will be par plus 1.5 times the index return, capped at 18% to 22%, according to an FWP filing with the Securities and Exchange Commission.

The exact cap will be determined at pricing. The payout at maturity will be par if the final index price is above the 85% barrier, otherwise investors will lose 1% for every 1% decline in the underlying asset.

The good stuff

At first glance, Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he liked the notes.

“This is certainly a nice and clean issue. Very easy to understand, including the underlying index. Everybody knows the Dow. We don’t have a problem with Bank of Montreal especially because to us, two-year is a short-term note,” he said.

“The leverage factor is very nice. You don’t need a huge return in the index to hit that cap.”

If the cap is set mid-point at 20%, the Dow only has to be up 6.5% a year to enable investors to receive the maximum return, which on an annualized compounded basis is 9.55%.

“So, it’s a little bit less than 10% but you’re being paid to be in the equity market. Ten percent meets my minimum requirement.”

Kalscheur however likes to invest conservatively. He often extends maturities to ensure sufficient protection. In that regard, the note did not meet his expectations.

Protection

“It’s the downside barrier that’s not as big as I would want it to be,” he said.

Kalscheur ran a quick back-testing analysis based on data he has collected on the Dow Jones industrial average since 1985. He found that on a 24-month basis, a drop in excess of 15% in the index occurred 7.4% of the time.

“Almost a 7.5% chance of losing money. That’s not insignificant,” he said.

In addition, the data established that the index finished negative 14.2% of the time.

“The barrier is cutting your probability of losing almost in half. That’s valuable. The barrier does a good job at reducing your risk. But is it enough?”

Kaplan said he was not convinced it was.

Another issue was the cost.

“This 2.75% fee on a two-year note is massive. That’s really, really high,” he said, commenting on the fee disclosed in the prospectus.

Record high

Another risk factor was the market’s current valuations.

“This is a good offering. But I’m not sure it’s pricing at the right time. The S&P, the Nasdaq are hitting all-time highs. We have this big Election coming up. The economic outlook is still uncertain,” he said.

“I’m locking myself in for the next two years.

“The world is not going to come to an end in two years.

“But I would much rather have that type of note in March when we were 35% off the all-time high. At that time, I was willing to take even mediocre terms, although the terms we were getting actually were really good.”

Given the current valuations in the U.S. equity markets, the need for protection is more relevant than before.

“I’m not sure I’m getting enough downside protection with this 85% barrier,” he said.

Given his outlook, Kalscheur was less worried about missing on the upside.

“My data show there is a 50/50 chance to outstrip the cap. I think you’re still doing very well with that cap. You’re going to collect your 10% a year and be happy,” he said.

“If the index is moving up slowly, at least the leverage is going to help you. Leverage is really useful in that middle-of-the-road scenario.”

But the downside protection was too much of a drawback.

“A 7.5% chance of losing money to me is significant for a structured product. We buy structured notes in our portfolios so that we don’t lose money. I would much rather have a buffer, even a 10% buffer, than this 15% barrier.

“In this current environment, I’d rather take a pass,” he said.

For others, the notes were not bullish enough, or perhaps not paying enough for the risk taken.

Upside

Steven Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management, did not like the cap.

“This kind of note would only appeal to somebody who believes we’re going to have a range bound market,” he said.

“You’re capped out at 18% to 22%. So, you believe the market will go up but not up very much. On the downside, you can live with a 15% barrier, so you’re confident the market will not go down a lot either.

“It’s a very specific view, not one that I at all embrace.

“If you are optimistic about the market, the index could go much higher in the next two years.”

The risk-adjusted return of the notes did not match this adviser’s view.

“Two years from now, hopefully, I suggest Covid is going to be in the review mirror,” he said.

“If you’re wrong however, the 15% barrier doesn’t give you much protection. It’s not a hard protection. It’s a barrier. It doesn’t give me enough comfort. I may give up a little bit of the barrier and replace it by a buffer.”

Post-Covid bull market

However, Foldes was more inclined to criticize the cap given his market outlook.

“Right now, the market is where it was back in February, when the economy was chugging along,” he said.

“There’s going to be a recovery.

“We know a vaccine should be available by year-end. We’re only four months from year-end.

“We expect some enthusiasm in this post-Covid period. Why would you cap your upside?

“10% a year doesn’t give you enough room to run.

“You also give up 2% in dividend yield. That’s 4% of the 20%. That’s a fifth of your return that goes away.

“The idea of limiting your upside without having a solid downside protection is not something we would be interested in,” he concluded.

Wells Fargo Securities, LLC is the agent.

The Cusip number is 06367W3J0.

The note s will price on Aug. 31 and settle on Sept. 3.

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