Bank of Montreal's 15.75% reverse convertibles tied to US Airways can provide hedge, yield

By Emma Trincal

New York, June 20 - Bank of Montreal's upcoming reverse exchangeable notes due Sept. 30, 2011 linked to the common stock of US Airways Group, Inc. can be used as an equity hedge as well as a potential source of income for investors who hold the view that the stock will trade sideways, a financial adviser said.

The three-month notes are expected to carry a coupon of 15.75% per year. Interest will be payable monthly, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par unless US Airways stock closes below the trigger price - 75% of the initial share price - during the life of the notes and the final share price is less than the initial share price, in which case the payout will be a number of shares of US Airways stock equal to $1,000 divided by the initial share price or, at the issuer's option, a cash amount equal to the value of those shares.

Like an option

"There are not good or bad products. It depends on the investor's view. If the client understands the risk, this is definitely one way of mitigating that risk and generating yield," said R. Scott Cramer, president of Cramer & Rauchegger, Inc.

If the stock price does not hit the trigger price, investors may use the notes as a hedge.

"This is like an option," said Cramer. "If the stock falls within a certain range and does not go up more than the coupon, this is a good way to generate income. People are really looking for yield right now.

"If you understand the risk of this product, it could be a good equity alternative for a portion of the portfolio."

Cramer said that the market risk would probably be an external event, if any, within the three-month timeframe.

"US Airways is a good company. But however good the company is, you still have exceptional events such as a spike in fuel cost or a terrorist event that could impact the stock. In a normal market, a decline of 25% probably wouldn't happen except in exceptional circumstances."

Slightly bearish

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that an investor in these notes would have to be almost bearish on the stock. But he did not view the notes as a hedging tool.

"I don't see the product as a risk reducer. It's a bet on a single stock. And it's a bearish bet at that if you don't think you can make 4% in the next three months."

Because the notes mature in three months, the actual coupon paid to the investor is about 4%.

"You're giving up the upside on the view that the stock will do less than 4% and better than negative 25%.

"That's not a very bullish bet. It's a bearish bet. You're almost shorting the stock at this point."

Roller coaster

Kalscheur said that the underlying stock was too volatile for his taste.

"It makes me nervous to get into a stock that not only can but has multiple times breached that threshold of 25%," he said.

The share price of US Airways lost more than 30% between early January and early March.

"That's a roller coaster," he said.

Kalscheur said that he liked the A+ rating from Standard & Poor's for this issuer as well as the very short duration of the notes.

The coupon was also a feature that could be used defensively, he noted.

"Granted, you do get the additional protection of the coupon, so it's less risky than investing directly in US Airways. But that risk is still significant. I think you're still taking some kind of a gamble."

Others said that the product offered an appealing risk/reward profile, making the risk-taking worthwhile.

Worthwhile risk

"The coupon is higher than you would expect from the market because the airlines industry is very soft and they picked the stock of a company that is soft itself within that industry," said Carl Kunhardt, Director of Investment Management and Research at Quest Capital Management.

"But I find this deal intriguing. What entices me is the short term of it. Something really bad would have to happen to trigger the threshold in a three-month timeframe."

Kunhardt emphasized that the real cushion protecting investors from downside risk was not a 25% but rather 29% decline, as he took into account the 3.95% coupon paid for the three months.

"Do I think the stock can go down 29% in three months? It's possible. But how likely is that to happen? Probably not very likely," he said.

The timing of the deal was also attractive, he said.

"Summer is the busiest flying time of the year. There is downside risk, but I think the downside risk is manageable in that short timeframe."

The notes (Cusip: 06366QPP6) are expected to price June 27 and settle June 30.

BMO Capital Markets Corp. is the agent.

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