Bank of Montreal’s 15% autocallables linked to oil & gas ETF stand at risky end of spectrum

By Emma Trincal

New York, Feb. 6 – Bank of Montreal’s autocallable cash-settled notes due Feb. 29, 2016 linked to the SPDR S&P Oil & Gas Exploration & Production exchange-traded fund come with a higher-than-average level of risk, making the product only suitable to investors who have a strong conviction about the oil stock turnaround story, said Tim Vile, structured products analyst at Future Value Consultants.

The coupon amount is 2.5% per month, or 15% per year, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically redeemed at par if the ETF’s closing share price is greater than 110% of the initial share price on any monthly call date.

If the notes are not redeemed, the payout at maturity will be par unless the final share price is less than the trigger price, 85% of the initial share price, in which case investors will be fully exposed to the ETF’s decline from its initial share price.

Call threshold

“This is an autocallable reverse convertible. It pays a fixed coupon of 15% per year, and it can be called monthly. The call is triggered at 110% of the initial price, not the usual 100 threshold. It reduces the chances to kick out. But investors’ expectations are bullish, especially in the light of a recent pick-up in the ETF price,” said Vile.

Another distinctive feature of the product compared to other reverse convertibles is the nature of the barrier, a so-called European barrier, which is only observed once, at maturity. By contrast, many reverse convertibles feature “American” barriers, which can be triggered on any trading day during the life of the notes.

“The European barrier makes it a lot safer for investors, especially when you’re dealing with such a volatile underlying,” he said, adding that the ETF’s implied volatility is above 40%.

Despite the European barrier, the market risk of the product as measured by the market riskmap is quite high, according to Future Value Consultants’ report.

The research firm assesses the market risk and the credit risk of each product it rates. It adds the two risk components together to calculate the overall risk, which it calls the riskmap, a score established on a scale of zero to 10 with 10 as the highest level of risk possible.

Market risk

The market riskmap of 5.73 is higher than the average score for the product type, which is 4.03, the report showed.

Several factors contribute to the higher risk, he explained, pointing first to the “relatively high” volatility of the underlying fund.

Since its peak in June, the EFT has lost 40%. But since mid-January, the price has soared 22%.

“Investors are betting that the fund, after having dropped so much and rallied over the past few weeks, is due [for] a turnaround,” he said.

But the risk is still there. The trend could reverse given the volatility. One additional element making the structure risky is the amount of protection.

“A 15% contingent protection isn’t that much for this type of volatility. However, investors may feel confident to place the trade despite the recent highs on the view that the price is still depressed relative to only a few months ago,” he said.

“It’s the same assumption that probably encourages investors to accept a 110% level as a condition for the call. This deal is based on a value bet. The bullish investors who would buy that note don’t expect the price of oil stocks to drop that much.

“However, the 110% threshold reduces the chances of being called and therefore represents another risk factor. On the other hand, the fact that you can get called each month is a plus for investors as you get more opportunities to pocket your return and get your full principal back. But you have to hit a higher threshold, and that makes it harder.”

The credit riskmap is “very small” at 0.10 versus an average score of 0.27 for products of the same type. This may have to do with the issuer’s high creditworthiness, he said.

Despite the good credit riskmap, the riskmap is much higher than the product type’s average at 5.83 versus 4.31, respectively. The high market risk is the main factor behind this result.

Return, price scores

The higher-than-average overall risk is going to have an impact on the return score, a rating for the risk-adjusted return of a product.

The return score, also measured on a scale of zero to 10, is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. The best of the five scenarios is selected to measure the risk-adjusted return on a scale of zero to 10.

With this product, the optimal scenario is low volatility.

At 5.50, the return score of the product is below its peers’ average of 5.90.

“We’re dealing with a relatively risky product. At the same time, the coupon is capping your return. You are not going to get more than 15% a year, and if you get called, you’ll only get a fraction of that. Anytime you have full downside exposure combined with a limited upside, your return score is going to be negatively affected,” he said.

Some of the same factors that contribute to the low return score also come into play to bring the price score down, he noted.

The price score is Future Value Consultants’ measure of a product’s value on a scale of zero to 10. The higher the score, the lower the fees and the greater the value offered to the investor.

The 5.51 price score is lower than the average for this category of notes, which is 5.82, according to the report.

The short duration is one factor. Future Value Consultants calculate fees on an annualized basis, so a short maturity will impact the price score negatively because the cost is spread over a shorter period of time, he said.

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The average overall score for reverse convertible autocallables is 5.86. In comparison, the notes have a 5.50 overall score.

“This product is not for everyone. For someone who wants a short maturity and a guaranteed coupon, 15% is attractive. But such investor has to believe that the sector is steadily recovering and that ultimately, prices won’t rise or fall by more than 15%,” he said.

BMO Capital Markets Corp. is the agent.

The notes are expected to price Feb. 25 and settle Feb. 27.

The Cusip number is 06366RZV0.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.