Bank of Montreal's absolute return notes linked to iShares Russell offer good value, return

By Emma Trincal

New York, Jan. 18 - Bank of Montreal's 0% contingent risk absolute return notes due Jan. 30, 2015 linked to the iShares Russell 2000 index fund have an attractive risk-reward profile and deliver good value, but the product is not for everyone due to a payout that offers a chance to outperform the underlying fund only on the downside and up to a point, said Suzi Hampson, structured products analyst at Future Value Consultants.

A barrier event will occur if the shares' closing level is less than the barrier level on any day during the life of the notes. The barrier is expected to be 68% to 72% of the initial fund level and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the fund's final return is positive, the payout at maturity will be par plus the fund return.

If the return is less than or equal to zero and a barrier event has not occurred, the payout will be par plus the absolute value of the fund return.

If the fund return is less than or equal to zero and a barrier event has occurred, investors will be fully exposed to the fund's decline from its initial level.

One of the reasons for the reduced chances of outperforming the fund, she explained, was the one-for-one upside participation with no leverage and no enhanced return features. Given that, the absence of a cap was irrelevant, she said.

"Having no cap is pretty standard when there is no enhanced upside except for principal-protected notes. The cap typically comes with the gearing, and you have no gearing here. It's just the fund minus the dividends," she said.

Range bound

"These structures can be appealing as you can make money if the market goes up or down, so it seems very attractive," she said.

"But as far as targeting a group of investors, it's not entirely clear who would benefit from it.

"If you're really bullish, you would prefer leveraging the upside or even a higher level of protection.

"If you think the market will be flat, you would be better off with an autocallable."

Assuming a barrier level of 70%, she added, "The only scenario where you outperform is if the index falls, but it has to fall by less than 30%, otherwise your risk is high. And you can breach this barrier any day, which increases the chances of a loss.

"So you're in an investment where you are not going to outperform the fund on the upside. You can certainly make money in a range-bound market, but if you have any bullish take on the market, you're better off with an autocallable or an income product, which will give you a chance to outperform.

"I can't really see who would be buying.

"There is however a market for those products, obviously. This one in particular happens to have very good scores."

Low credit risk

The notes show a low risk level as measured by the riskmap, a Future Value Consultants indicator that measures the risk associated with a product. The higher the riskmap on a scale of zero to 10, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

The riskmap of 2.90 for this product is less than the average product type at 3.22. Hampson explained that the difference results from this issuer's superior credit riskmap (0.22 versus 0.62 for similar products) rather than by the market risk, which at 2.68 is in line with the 2.60 average of equivalent products - in fact, even a little bit higher.

"It's quite low risk, especially compared with all products. The credit risk is lower because it's Bank of Montréal," she said.

Five-year credit default swaps for the Canadian bank are 35 basis points, compared with 130 bps for Citigroup and 185 bps for Morgan Stanley, for instance, she noted.

Risk-reward profile

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

"The only thing that's really going to hurt you is breaching the 70% barrier. You don't have to make a huge return," she said.

"We're looking at a low-volatility scenario. That's the best assumption for this particular product. It would reduce the probability of higher return and increase the chances of getting something more average, but at least something.

"This is not really an ambitious product for investors. I don't think people aiming for very high returns would choose these types of notes."

According to the probability tables and under the optimal low-volatility assumption, investors have a 34.2% probability of generating an annualized return comprised between zero and 5%. The chances of a per annum gain in excess of 15% are only 5.4%. On the downside, there is a 12.6% probability of losing more than 15% a year.

The notes, with an 8.38 return score, show a better risk-reward profile than their peers, which have an average 7.72 score.

"It's not clear exactly why the return is better than similar products. It could be that other products are capped while this one is not. If that's the case, the absence of a cap would have a very positive effect here," she said.

Price, overall

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score, at 9.24, exceeds the 8.19 average for similar products.

"It's a very high price score. The investor is getting good value for his investment," she said.

With its overall score, Future Value Consultants offers its opinion on the quality of a deal. The score is simply the average of the price score and the return score.

At 8.81, the notes have a high overall score, superior to the average of the same product type (7.96) and also better than all products (6.69).

"The score is the combination of the return score and price scores. Usually one of the two offsets the other, pushing down the overall. But in this case, both are excellent, so naturally, you're getting a very high overall," she said.

BMO Capital Markets Corp. is the agent.

The notes will price Jan. 28 and settle Jan. 31.

The Cusip number is 06366RLE3.

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