Bank of Montreal's autocallables tied to Russell ETF seen as risky given index's recent highs

By Emma Trincal

New York, June 6 - Bank of Montreal's 0% autocallable cash-settled notes with step-up call price due June 30, 2015 linked to the iShares Russell 2000 index fund, although attractive for their potential yield, offer too much risk given the volatility of the underlying fund, sources said.

The notes will be called at a premium of 10% per year if the fund closes above the initial level on either of two annual call dates, according to a 424B2 filing with the Securities and Exchange Commission.

The call dates will occur on June 25, 2014 and June 25, 2015, just before the maturity date.

The payout at maturity will be par if the fund falls by up to 15%. Investors will share in the fund's losses if it falls below the 85% trigger level.

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said that the Russell 2000 may be too high to warrant the risk of losing one's entire principal for a limited upside.

More protection, please

"I like the Russell as an asset class for the next couple of years. It had a very nice appreciation this year and has held up well relative to the recent pullback of last week through this week," he said.

"With this in mind, I'm not sure that I'm too keen on the autocall. Whenever you're taking the equity risk of a relatively risky asset class and capping it at 10% when the Russell has doubled that in the last six months, I think you should be somewhat cautious."

The notes do not guarantee any return of principal, the prospectus warned.

Investors may lose up to their entire investment at maturity if the notes are not called. In such scenario, the payout at maturity could be either par or, if the trigger is hit, a loss of at least 15% of principal up to potentially 100%. A trigger event would expose investors to a one-for-one loss from the initial level.

"Because it is a riskier asset class, my preference would be for a bigger buffer," Medeiros said.

"My philosophy has always been that when you take equity risk, you should get equity reward. The reward could be a higher premium or a bigger buffer. One could argue that the buffer is too small and the cap too low. But you probably can't improve both.

"To me, part of the reward should be a very attractive buffer based on the standard deviation of the Russell index.

"If I had to choose between the cap and the buffer, I would go for a more protective structure. My priority would be on the downside protection."

Annual call dates

One advantage offered by this product is that it limits reinvestment risk due to the yearly frequency of the call dates versus a product whose return would be monitored on a quarterly basis, which is more common, sources noted.

The prospectus defined reinvestment risk as one of the consequences of the automatic early redemption - the potential inability for the investor to reinvest his proceeds at a comparable rate of return.

The structure limits the reinvestment risk to one time in the life of the product, a year from the issuance date. As a result, if the notes were to be called in June 2014, investors would at least get the full premium, noted Steve Doucette, financial adviser at Proctor Financial.

"Maybe having a call date annually rather than quarterly can help, maybe it won't. It's nice to know that you're going to get at least the full 10% premium if you're called and not a fraction of it like 2.5%. But at the same time, who knows what the market is going to be in a year?" he said.

Overbought underlying

Another risk associated with autocallable notes is the limitation of the upside. The prospectus stated that the return will not exceed the 10% per year call price even if the index appreciates above that.

But sources were not particularly concerned by the upside risk given the strong performance of the iShares Russell 2000 ETF, which is up 14% year to date and 29% over the past 12 months.

"Those autocalls are the best things in the world when you want to minimize your fixed-income exposure and capture some yield, but you'd better do that when the index is down. Now that the Russell is at an all-time high, it's a different story," Doucette said.

"We did those in 2008 and 2009, and we captured very good returns.

"We have some coming due in January, and it's going to be a hard call to decide whether we want to take that unlimited downside risk in order to capture that coupon.

"The index right now is just below its peak.

"I would have a hard time to buy this note at those levels. You have that semi-protection down to 15%. But a 15% drop from where we are right now, that could certainly happen any time.

"We've had a pullback in the recent trading days. I'm not saying it's a correction. But the market was overdue for an adjustment. Is it the end of the bull market? Who knows?

"With all this uncertainty and the market levels as high as they are right now, I'd be hesitant to get into this note today."

BMO Capital Markets Corp. is the agent.

The notes are expected to price June 25 and settle June 28.

The Cusip number is 06366RPB5.

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