BMO’s $1.24 million buffered notes on Dow too conservative, almost bearish, adviser says

By Emma Trincal

New York, May 2 – Bank of Montreal’s $1.24 million of 0% buffer return notes due April 29, 2027 linked to the performance of the Dow Jones industrial average show a large buffer with a capped, unleveraged upside over a longer-dated note, financial advisers noted.

While the structure is appealing to one adviser due to its defensive attributes, another would have preferred to see more upside potential given the lower risk of decline over the period.

The payout at maturity is par plus any index gain, subject to a maximum return of par plus 82.75%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 20% and will lose 1% for each 1% that the level of the index decreases by more than 20%.

Concentrated benchmark

Carl Kunhardt, wealth adviser at Quest Capital Management, said he liked the structure more than the underlying index.

“It’s very plain-vanilla. There’s not a whole lot you have to explain to someone, which I like,” he said.

“I also like that it’s linked to a single index. It’s not a worst-of.”

But the underlying was not his favorite index.

The Dow Jones industrial average, he said, is overly concentrated and does not offer a true representation of the U.S. stock market.

“It’s only 30 stocks. People assume it reflects the equity market but that’s not true,” he said.

Most notes are tied to the S&P 500 index because of the greater number of constituents, he said.

“The S&P tracks the stock market more closely,” he said. “If you really want a benchmark for the overall stock market, you should use the Wilshire 5000 index. Interestingly, we don’t see this underlying.”

Another drawback was the tenor.

“Five years is a little bit long,” he said.

Cautious investors

Kunhardt said he found the note more attractive than a long position due to the defensive nature of the investment.

“Over the next five years, there’s a pretty good chance to assume the Dow will be up,” he said.

“The 20% buffer is very safe. If you’re a cautious investor, it’s a good fit. Worst case scenario you get your money back.

“Am I better off with the notes or with a long position in the index? To me it’s the notes, just because of the buffer. It’s always good to have it.”

The entry point of the trade was also timely.

“The notes priced last week and we’re clearly in the trough. GDP was negative in the first quarter. You’ve got to feel good about the chances of being up over a five-year term,” he said.

The cap was not a deterrent.

“You get a 16% annual return. Anything above that, you’re just being greedy,” he said.

“I would probably do this note even though I’m not in love with the index.”

Credit, index, cap

A financial adviser said he liked the cap level and the underlying. But he found the buffer overly conservative, adding costs to the structure that may have been better deployed to enhance the payoff.

“The issuer’s creditworthiness if just fine. Canadian banks are solid,” he said.

Bank of Montreal is rated A+ by S&P Global Ratings.

“I’m comfortable with the exposure. It’s the Dow. You can’t get more straightforward than that. It’s good from a client’s standpoint,” he added.

“The cap on a compounded basis is about 13%. If I can get into an equity investment and get that double digit return, especially in this environment, I’m happy with that.”

Long tenor, big buffer

However, the issuer could have improved the upside, he said.

“Normally I like to see some leverage on the upside especially on a five-year note. Most five-year notes don’t have a cap at all. The reason you have one is because of this enormous buffer,” he said.

Was the buffer worth capping the upside and giving up the leverage? For this adviser, the answer was: no.

He ran back-testing figures for five-year rolling periods on the Dow since 1985. He found that the frequency of finishing negative over a five-year period was only 1%.

“It’s irrelevant,” he said.

In addition, when the note priced on April 26, the Dow was already 10% off its Jan. 5 high.

“The chances of being down 20% in five years while we’re already down 10% are ridiculously low,” he said.

The issuer had doubled down on the safety of the note by combining a long tenor and a large buffer, he added.

“On a two-year I would jump on it. You need that. But on a five-year period, it’s almost a waste.

“To protect your principal, you can either have a big buffer or a longer maturity. But do you need both? Not really,” he said.

Reshuffling

Several solutions could make the structure more attractive.

As he noted, the 20% buffer would be useful on a shorter note.

Alternatively, the downside protection could be cut in order to provide improved gain potential.

For instance, he said he would rather have a 15% or even 10% buffer on a five-year note with some leverage, perhaps 1.5x or 2x leverage.

“I usually never complain about having downside protection. We’ve been preaching it for years to our clients,” he said.

“But this is excessively defensive, even almost bearish.

“You would do much better with a lower buffer or even a barrier and some leverage and maybe some absolute return.”

Excessive pessimism

One problem is the “high” fee, he noted, which is 3.3%, according to the prospectus.

“That’s way too high. A lower fee would give you better terms. You always have to pay for everything,” he said.

Reducing the buffer size and adding leverage may also call for a higher cap.

“I ran the numbers for five-year rolling periods on the Dow Jones since 1985. What are the odds that you’ll be over the cap? Well, it’s 26.3%. That’s better than 50/50 but it’s still high,” he said.

In conclusion, this adviser said the structure was not sufficiently balanced.

“The issuer could have done a better job with the risk return tradeoff,” he said.

“Most notes are overly liberal. This one is too conservative. Wall Street is overly pessimistic right now. But as an investor, including a buyer of structured notes, you have to be a little contrarian.”

BMO Capital Markets Corp. is the selling agent.

The notes settled on Friday.

The Cusip number is 06368GNZ6.

The fee is 3.3%.

© 2015 Prospect News.
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