Bank of Montreal's 16% reverse convertibles tied to Yahoo! involve headline, market risks

By Emma Trincal

New York, Dec. 5 - Bank of Montreal's 16% annualized reverse exchangeable notes due March 30, 2012 linked to Yahoo! Inc. shares, despite attractive terms, may be a hard sell for bearish and bullish investors alike given the volatility of the underlying stock and the headlines associated with the internet company, sources said.

Sources noted that the share price has been very volatile as headlines point frequently to failed turnaround initiatives.

Moreover, rumors of a takeover may put a lid on the potential upside for note investors compared to those buying the shares outright, they said.

The payout at maturity will be par unless Yahoo! stock ever closes below the trigger price - 75% of the initial share price - and finishes below the initial share price, in which case the payout will be a number of Yahoo! shares equal to $1,000 divided by the initial share price or, at the issuer's option, the cash equivalent, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable monthly.

"It's a very generous note, and I like the fact that it's only a three-month," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"They give you a 16% coupon and a 25% protection, which is significant."

Kunhardt said he prefers to invest in broad indexes rather than in specific names.

But his main objection with the product was the limited return given the stock upside potential.

Takeover and cap

Kunhardt pointed to recent news reports saying that Yahoo! was considering several buyout proposals, in particular, one from a consortium of private equity firms including Blackstone Group and Bain Capital along with Alibaba. A takeover bid would make the note less attractive on the upside, he said.

"If there's an offer, that stock is going to appreciate hugely and by much more than 4%," he said.

The 4% amount is the cap for the notes over the three-month period, based on the 16% annualized interest payment.

The notes, despite the 25% downside protection, also put investors' capital at risk given the volatility of Yahoo!'s stock price, he added.

The prospectus mentioned that investors can lose up to their entire principal amount, something that can happen if the 75% barrier is breached at any time during the three-month period and if the stock declines by that amount.

"My concern with Yahoo is that their corporate governance is in such turmoil most of the time, it's going to be a volatile stock until they have their house in order," said Kunhardt.

"The chances of breaching the barrier are real. You're kind of rolling a little bit of a dice," he said.

Fragile barrier

For Michael Kalscheur, financial adviser at Castle Wealth Advisors, reverse convertibles in general do not offer a natural fit for his clients. But he said that this one in particular would be too risky even with the 25% cushion as the stock has a track record of significant price swings.

The risk, he said, was more market-based than related to the credit of the issuer.

"Bank of Montreal is a single-A+. That's encouraging," he said.

"And on a three-month note, I'm not as concerned about credit risk. A three-year would be a bigger issue."

Kalscheur's main objection was the likelihood for the stock to drop by more than 25% in a three-month period.

"If you look at the prospectus, you see that they broke the 25% limit just in the third quarter of this year," he said.

The high of this year's second quarter was $18.65 on May 6.

For the third quarter, the stock fell to an $11.09 low, on Aug. 9.

In three months, the stock lost 40.5%.

"The third quarter in the U.S. did not have a lot of bad news. There was no recession. People just got spooked out of the market," he said.

"What would it be like if we had had real issues?

"Imagine that Europe falls apart; everybody's scared; the market drops 15%. In such case, Yahoo would drop by 30%.

"This doesn't give me a lot of solace.

"This stock could easily break the 25% threshold. For me, that's not enough of a safety net," he said.

The fact that the stock has gained 23% over the past three months adds to the risk of a price decline looking forward, he said.

Potential investors in the notes need to pay attention to the stock level on pricing day, at the end of the month, he added.

Kalscheur compared the investment in the notes to the purchase of the underlying stock.

"If I bought the stock outright, the notes would give me an advantage with the 25% downside protection," he said.

"But I would only buy the shares if I was bullish on the stock. And in that case, why would I limit my upside to 16%?

"From my perspective, it doesn't really work. If I'm bullish on the stock, I'd buy the stock. If' I'm bearish, the downside protection is not enough," he said.

Specific tax use

Kalscheur said that he could use the notes for a particular tax strategy, which would only apply to a limited number of people.

"If I had a client who owned some Yahoo shares and would want to sell them but for capital gains or losses purposes, I could see how this note could serve a very specific purpose," he said.

In his hypothetical example, the client would want to sell his shares in January rather than in December in order to record the capital gains or losses for the following tax calendar year.

The notes, in this context could be used as a hedge for this position until the sale is executed in January or in the first quarter.

"Instead of buying a put to protect the stock against the downside, they would buy the notes and make some money out of it with the coupon, as opposed to buying the put, which would be an outlay of cash," he said.

"However it would be an imperfect hedge. It wouldn't be as good as a put.

"But I could make the case for utilizing this product as a hedge or partial hedge for a very short period time with this tax strategy in mind," he said.

BMO Capital Markets Corp. is the agent.

The notes will price on Dec. 22 and settle on Dec. 30.

The Cusip is 06366QN78.

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