Bank of Montreal's contingent absolute return notes tied to MSCI EAFE seen best as a hedge

By Emma Trincal

New York, March 11 - Bank of Montreal's 0% contingent risk absolute return notes due March 28, 2016 linked to the iShares MSCI EAFE exchange-traded fund give investors the opportunity to make money even in a declining market, but the protection and the absolute return features are limited to a narrow range of index decline, which makes the product more advantageous as a hedge rather than a stand-alone investment, sources said.

A barrier event will occur if the fund's closing share price is less than the barrier level on any day during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

The barrier level is expected to be 72% to 75% of the initial share price and will be set at pricing.

If the fund return is positive, the payout at maturity will be par plus the fund gain. If the fund return is zero or negative and a barrier event has not occurred, the payout will be par plus the absolute value of the fund return.

Otherwise, investors will be fully exposed to the fund's decline from the initial price.

For Tom Balcom, founder of 1650 Wealth Management, the profit zone of the payout was narrow and the conditions in which the notes would outperform the underlying fund are not necessarily easily met.

No return enhancement

Investors have to forego the 2.5% dividend yield, giving up 5% over the two-year period, he said.

"You can't be bullish and buy the notes. If you're bullish, why would you sacrifice the dividends? You're going to lose 5% with this note over two years. If the total return of the index is 10%, you're only going to get 5%.

So this is not for a bullish investor because you know that you're going to underperform the index.

"If the index is down by more than 25%, you're going to lose one to one on the downside. So you can't be too bearish either.

"The only way you would outperform the index would be if the market was down but not down by more than 25%. In that case, whatever market decline in that range would be a gain for you.

Thread of a needle

"But it's a narrow range. The market has to finish down anywhere between 100% and 75%. It's the thread of a needle."

Given the fact that the scenario in which investors outperform the underlying may not have a high probability of happening, Balcom questioned the rationale of giving up dividends and any return enhancement on the upside for the absolute return feature.

"The downside risk involved with breaching the barrier is obvious. But there is also some upside risk. What if the market is up? What's my advantage?

"I'd prefer to have some kind of leverage on the upside even with a cap to compensate for missing the dividends on the upside. It would make the notes more appealing.

"You know that you're going to lose money if the index drops a lot. You are going to underperform if the index is up.

"You can't just be bearish. You have to be moderately bearish. And you also have to be moderately bearish and correct."

Because the chances of "being correct" may be limited, Balcom said that the notes offered little appeal as a stand-alone investment.

A complement

"But it might be a complement to a long-only exposure," he said.

"As a hedge, it could make sense. You're offsetting a long-only position with a downside protection that exists to a degree. It wouldn't work as a replacement for a long-only position but perhaps as a complement.

"I can see the use of it for people who want to hedge an exposure to the EAFE. You don't have the dividends and you're only hedging to a degree. But at least you're getting a pretty good hedge," he said.

Twin-win

Michael Iver, chief executive of iVerit Consultancy and former structurer, agreed that there was no room for error for the investor in assessing the amount of decline in the index.

"This structure is popularly known in Europe as a twin-win because it provides a positive return on both sides," he said.

"It's an American-style knock-out twin-win because if the barrier is breached any time during the two years, the investor loses the benefit of the absolute return feature and he also loses the downside protection.

"The investor may not be sure about the direction of the market. The market may go up or down. But there is one thing the investor needs to be sure about - and that is that the market won't decline by more than 25%.

"The reason you have to be highly confident that the market is not going to fall by that much is because when there is a knock-out, you're not only losing 25% in protection, you're also losing 25% in gains. That's a 50% return you're losing. That's huge. The knock-out event is significant and is likely to reduce the cost of the puts. Even if the probability of getting knocked out was low, the event itself has a high severity."

Two puts

Iver described the absolute return and downside protection features in options terms.

"The barrier can be struck any day, and if it happens, it will extinguish the benefit of the positive return on the downside; this is why it's an American-style barrier," he said.

The term "American" refers to an "American" option, which can be exercised any time until the expiration of the contract, unlike European options, which are exercised at expiration.

"With this note, you are long the index and you are long two at-the-money puts and both puts have an American-style knock-out struck at 75%," he said.

An at-the-money put would have the 100 initial price as a strike. By being long the put at the money, investors in the notes are protected against declines in the index below the initial price.

"But the protection is limited. The knock-out terminates the put if the 75% strike is hit," he explained.

"If the index is down 24.99%, you get 24.99% in return. If it crosses that barrier, if it's down 25%, you lose 25%.

"The first put gives you the protection for your long position. You don't lose anything. Instead of losing nearly 25% you end up flat.

"The second put provides the positive return on the downside, what they call the absolute return up to the 75% barrier. This time, instead of losing 24.99%, you end up making a 24.99% gain.

"The first put protects you. The second one gives you the positive return. Between the two, it's like a 50% change in return. Instead of losing 25%, you're making 50%. You have a lot to lose by hitting that strike," he said.

Better be sure

For Iver, investors are not too concerned about underperforming the index on the upside as a result of not getting paid interest and dividends.

"They only lose in relative performance," he said.

The view is non-directional but the investor wants to capture gains if the index falls, which is possible as long as the decline doesn't trigger the knock-out, he said.

"The investor has to be super confident that the decline in the index will not be too steep however.

Investors only win in a small decline scenario, which led Iver to also conclude that the product would be best used as a hedge.

"It would be a good idea for an investor who is not fully invested in the EAFE, who wants to add to his current exposure but at the same time, who also wants to add protection to it," he said.

"The second put in this case acts as a hedge against their current long exposure to the index.

"This would be useful for an investor who wants to put more money into this asset class but who is a little bit afraid to do so."

The notes (Cusip: 06366RTQ8) are expected to price on March 20 and settle on March 25.

BMO Capital Markets Corp. is the agent.

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