Bank of Montreal’s leveraged notes tied to EAFE ETF offer slightly buffered alternative to ETF

By Emma Trincal

New York, July 20 – Bank of Montreal’s 0% buffered bullish enhanced return notes due Oct. 31, 2016 linked to the iShares MSCI EAFE exchange-traded fund offer a short-term alternative to a long position in the international benchmark, sources said.

The payout at maturity will be par plus 200% of any fund gain, subject to a cap of 16% to 18% that will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to 5% and will lose 1% for each 1% decline beyond the 5% buffer.

“The buffer is decorative, but it’s better than nothing,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“The notes are not particularly attractive, but from a broader perspective, you should have developed markets exposure.”

European proxy

Kunhardt compared the notes with an equity position in the fund and said the structured product offers the benefits of the downside protection and enhanced return.

“If you’re going to hold these exposures long, you’ll have to have some downside exposure in these two positions,” he said.

“But the notes give you some protection. It’s small, but whatever it is, it’s still a buffer, so you can’t just disregard it.”

The relatively short tenor makes the cap more acceptable.

“You’re capped, but I don’t really mind because it’s a 15-month product, not a five-year note,” he said.

“When you’re talking about the EAFE, you’re really talking about Europe. Is it reasonable, practical to expect European equity markets to go up 6% to 8% a year? Of course it is!

“They have to deal with the Greek crisis. But take a look at German exports. I don’t think a Greek default is going to have a devastating impact on Germany.

“And the other problematic countries – Spain, Portugal, Ireland ... along with Italy... – they’ve all taken substantial steps to fix their economic house and improve their bottom line.

“Europe is now sitting in a much better position than two years ago.

“I don’t think it’s a stretch to expect this index to be up 8% in a little bit more than a year. It’s an eminently realistic expectation. I don’t like caps, but this would give me 16%, and that’s not bad.

“If I held the position long, I would have the full downside exposure. With this, I am not expecting any upside above 16% in 15 months. That’s my only risk. I think it’s a reasonable risk and a reasonable expectation.”

Emerging markets version

Simultaneously, Bank of Montreal announced in the same filing another deal identical to this one except for the underlying and cap.

This second 15-month bullish enhanced return note is based on the iShares MSCI Emerging Markets ETF. The leverage multiple, maturity date and buffer amount are the same, but the cap is higher at between 18% and 20%.

Kunhardt said that from an “outlook” perspective, he prefers the notes linked to the EAFE but that the second deal is also a good alternative to an outright investment in the fund.

“Take the U.S. Right now we like large caps better than small caps. Does it mean we’re going to remove small caps from the portfolio? Of course not!

“Even though we’re biased toward developed markets, there is a place in the portfolio for both of them.”

Buffer and term

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he likes the terms of the EAFE notes, especially the protection despite its small size.

“It’s a baby buffer, but it’s a real buffer. The market goes down 10%, you’re actually protected by 5% and your client only loses 5%. That’s always good to have,” he said.

While a “bigger” buffer would certainly be “better,” he made the case for having downside protection with short-term products.

“We always believed that chances of incurring losses are greater over the short run,” he said.

“Give me a 20% buffer on a five-year and I would be tempted to say, ‘You’re wasting my money.’

“Those buffers cost you something in yield, in dividend. The EAFE index yields 2.67%. It’s 70 basis points more than the S&P 500.

“Of course a bigger buffer would be better, but a useful buffer is good too.

“If you’re going to pay for some protection, you might as well have some reasonable probabilities of using it.

“We value a buffer based on the amount of protection and also based on the probability of using it.

“This little one is likely to be useful. So we like it.

Outcomes

Kalscheur said he likes to pick a note based on his chances of winning.

“I need to win two out of three. This one fits the bill.

“If the index is way up, I am capped at 16%, but most clients would be happy with that.

“If the index shows an average growth between 5% and 10%, it makes up for the dividend loss and I’m still winning with the leverage.

“If it’s flat, I may lose because of the unpaid dividends.

“If I’m down, I would be ahead by at least 5%.”

Equity bucket

The terms of the notes would be attractive to a client already invested in the developed markets who is seeking additional exposure.

“It’s not a safe investment. I wouldn’t put it in our alternative bucket. Alternative for us would have more protection and would be long term. This is not designed to act much differently than the market. It would go to our equity bucket,” he said.

“I can see myself putting some assets in this, not to replace an entire allocation but perhaps to hedge some active manager position.”

Kalscheur said that if he “had to pick between” the EAFE product and the emerging markets notes, he would choose the former.

“The cap is a little lower, but it’s less volatile. If I have to have the same 5% buffer, I would go for the less volatile index,” he said.

“Either way, these are two good offerings. I’d like to see the fees. But the terms of the notes are very nice.”

The prospectus, which contained information on both upcoming deals, did disclose any fee amount.

The notes linked to the EAFE ETF (Cusip: 06366RU52) and to emerging markets fund (Cusip: 06366RU60) will price July 28 and settle July 31.

BMO Capital Markets Corp. is the agent.

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