Bank of Montreal’s absolute return notes tied to Euro Stoxx offer defensive, range-bound bet

By Emma Trincal

New York, May 31 – Bank of Montreal’s 0% contingent risk absolute return notes due June 30, 2022 linked to the Euro Stoxx 50 index may be an alternative to a direct equity investment for investors who want to cautiously allocate to the European equity market without having a strong conviction on the direction of the benchmark, advisers said.

If the index return is positive, the payout at maturity will be par plus 110% of the index return, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is less than or equal to zero but not less than negative 30%, the payout will be par plus the absolute value of the index return.

If the index return is less than negative 30%, investors will be exposed to the index's decline from its initial level.

Defense

The notes should be used primarily as a defensive tool, not in an attempt to outperform the underlying index, said Tom Balcom, founder of 1650 Wealth Management.

“It’s designed for clients who want exposure to the Euro Stoxx but are uncertain about the future,” he said.

“Sometimes those products are sold. I mean they may not be clearly explained to the client. A broker could easily say, you get uncapped return with leverage on the upside and you can make money up to a 30% decline. Wow!

“And there is nothing wrong with that if the client understands what they’re giving up.”

The Euro Stoxx 50 yields 3.12%, which is 18.75% over six years, he noted, adding that noteholders have to agree to part with this amount of income, as noteholders are not entitled to receive dividends.

“You’re not going to outperform the index on the upside because you’re not getting 18.75% in dividends,” he said.

Downside

The absolute return feature enables investors to outperform the index downward but only between two points – minus 10% and minus 30%, he added.

At an index decline of 10%, the absolute return enhancement starts to yield better results than the buffering benefit of the dividends.

“After a 10% loss approximately, it becomes beneficial to own the notes rather than the index,” he said.

The limit to that range of profits is a 30% decline as investors lose at least 30% of their principal once the barrier is breached.

“If you take dividends into account, you can really outperform the index on the downside between a 10% and a 30% decline,” he said

Cautious investors

Balcom said the notes are not bearish though due to the risk associated with the barrier.

The notes are not a bullish investment either, he noted: “If you were a bull, you’d want the total return of the index. It’s a defensive play in my book.”

The notes may be suitable for risk-averse investors. But the structure – in particular, the non-payment of dividends – has to be fully explained to the client, he said.

Full disclosure

“They would have to understand the trade-off. People usually don’t. They don’t deconstruct the index, and they don’t always understand the difference between price return and total return,” he said.

“They’re giving up the dividends, which is a sizable hard buffer for the absolute return, which gives them contingent protection and gains up to a 30% drop,” he said.

If investors are “happy” with the trade-off, they may find the notes very useful, he said.

“For a client who would say, I want exposure to Europe but I’m scared ... here’s a way of tiptoeing in the market with some protection out there. At least the note can assuage their concern about future volatility in Europe if they need to make a small allocation to this asset class.”

Tenor, income

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said the notes may be appropriate for those investors who view the index trading within a specific range.

Stressing first the drawbacks, he pointed to the long tenor and the non-payment of dividends.

“Six years is a long time. Personally it’s way too long for any note that’s not providing income,” he said.

“You’re not getting 18.72% in income for six years, which is a hefty sum most people wouldn’t want to give up.

“But if you omit this and look at the performance of the index, it sort of makes sense.”

Mid-range

He looked at the current price of $34.00 a share for the SPDR Euro Stoxx 50 index exchange-traded fund, which replicates the Euro Stoxx 50 index.

The 70% barrier would correspond to a price of $23.80. Such level is lower than the index low in February 2009, he said.

“Thirty percent down from here gives you a protection that’s below the 10-year low,” he said.

On the upside, a 30% increase from today’s levels would bring the price to its May 2014 high of $44.20.

“We are now right smack in the middle of the range,” he said, referring to the current price at mid-point between the high and the low.

Near the end

“From a risk-reward perspective, six years is a long time. But if you make the assumption it will be trading 30% up or down from where it is at now, within a range, of which we are in the middle, this is a reasonable note. You get the upside, and the downside is positive,” he said.

“If the index is not going to move much, if it’s going to close near to where it’s at now, you’re going to be better off with the index,” he said.

“But if you see the price stretching to the end of the range, then you would benefit from holding the notes.

“It really depends on what your view of the market is.”

BMO Capital Markets Corp. is the agent.

The notes are expected to price June 27.

The Cusip number is 06367TFE5.

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