Bank of Montreal's 17% reverse convertibles tied to Yahoo! offer value, high potential return

By Emma Trincal

New York, Sept. 23 - Bank of Montreal's 17% annualized reverse exchangeable notes due Dec. 30, 2011 linked to the common stock of Yahoo! Inc. give investors good value and a "decent" potential return given the risk, said structured products analyst Suzi Hampson at Future Value Consultants.

Interest will be payable monthly, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par unless Yahoo! 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 Yahoo! stock equal to$1,000 divided by the initial share price or, at the issuer's option, the cash equivalent.

"This is a short-term reverse convertible, a high-yield, high-risk play," said Hampson.

"With an annualized return of 17%, which is quite high compared to the risk-free rate, you would expect to have a reasonable risk associated with it."

Versus the stock

Reverse convertible notes should be compared to stocks, and they should be purchased by investors who want income but who also like the stock without expecting too much growth from it, she said.

"It's a different way of investing in a stock," she said.

"First, you have to like the underlying stock. You can't just pick those notes based on the coupon; that would be like picking a stock with the highest dividend.

"Second, rather than for growth, you buy those products for the guaranteed income hoping that the stock won't fall below the barrier, so that you can get the maximum payout, which is your coupon.

"So if you like Yahoo!, you should decide whether you want to buy the stock directly or whether you prefer to get the exposure via a note like this one.

"If you think that Yahoo! is going to fall by 25% in the next three months, you would avoid both the stock and the reverse convertible anyway.

"But the note gives you more protection than the stock, and that's the main difference. Once the barrier is breached, you still get your coupon, so you'll get slightly more money back than if you were directly invested in the stock.

"The flip flop is that your stock return is capped."

The implied volatility of Yahoo! is 52%, said Hampson. In early July, it was about 40%.

"The volatility of the stock picked up with the overall rise of volatility in the market," she said, adding that the implied volatility of the S&P 500 index is now 29% and was only about 22% two months ago.

"When you compare a single stock with a broad equity index, you expect more volatility."

But some stocks show a much higher volatility level, as high as 60% or 70%.

"Yahoo! is not among the most volatile stocks. That's one of the reasons why the risk for those notes is less than for the average of the same product type," she said.

Risk

Future Value Consultants gives its assessment of the risk of a product with the riskmap, a rating that measures the risk associated with a product on a scale of zero to 10.

The rating compares the average product underperformance (relative to cash) with the average underperformance of five sample assets of different volatility levels. The risk rating equates the risk of the products against the five hypothetical assets.

For those notes, the riskmap is 5.77 versus 6.35 for similar products. The same type of product category includes all reverse convertibles regardless of their duration and downside protection type.

"I think there are riskier reverse convertibles out there with underlying stocks that are much more volatile," she said.

"In addition, the 75% barrier gives you a 25% cushion. It's much more than what you see in many other reverse convertibles, where the protection is only worth 15%, 10% or even only 5%.

"The volatility level and the barrier type contribute to make this deal slightly less risky than other comparable structures.

"You wouldn't want to interpret that as saying the notes are low risk. It's high risk, but perhaps not as high as other similar products."

Riskmap is the sum of two risk components: market risk and credit risk.

With these notes, the bulk of the riskmap comes from the market risk, Hampson said. That's simply because the credit risk is relatively limited.

"It's a three-month product, and in three months, the chances of a default are slim compared to a five-year bond for example," she said.

Price score

Another positive aspect of the product is its high price score.

Based on a scale of zero to 10, the price score, which for this product is 9.52, represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis and profit margins on the underlying derivative.

"It's scoring quite well," she said, adding that the price score is better than the average for all products rated by Future Value Consultants (5.64) and even better than the average for similar products (3.99).

"If the price score is high, it means that we value the assets highly and you should expect a good return score," she said.

"We think with this price score that the value of the coupon is high.

"Even if the level of risk is elevated, it's still less risky than the average.

"And you're getting a high return given that level of risk."

Return score

The return score is Future Value Consultants' opinion of the risk-adjusted return under reasonable and consistent forward-looking assumptions for underlying asset evolution. It is measured on the same scale of zero to 10.

The notes received a return score of 6, compared with 5.45 for the average return score of similar products.

The return score derives from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

The probability table associated with this product shows that the odds of generating an annual return of more than 15% are about 78%.

On the other hand, investors have a 22% chance of losing more than 15% of their principal.

"If the stock falls below the 75% barrier, you're likely to lose at least 25% because it's only three months. By the time you hit the trigger price, you are not going to have enough time to go back up above zero.

"So you have more limited chances to lose, but if you lose, you lose a great deal.

"On the other hand, you have a high probability of getting your coupon and making more than 15%.

"A 22% chance to lose versus a 78% chance to win represents a good split for a reverse convertible. We've seen similar products where the split is more like 40%-60%."

Good overall

Future Value Consultants delivers its opinion on the quality of a deal with its overall score. The score is based on the average of the price score and the return score.

The overall score for the notes is 7.76. It is higher than the average score for all products at 5.85 and the average for similar products, which is 4.72.

"Based on the parameters we have, this is doing well on value and return. It suggests the value to the investor is high and you have a good chance of return given the risk you're taking," she said.

The notes (Cusip: 06366QXM4) are expected to price on Tuesday and settle on Sept. 30.

BMO Capital Markets Corp. is the agent.

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