BMO’s buffered bullish leveraged notes tied to Russell 2000 seen as ‘well done’ by adviser

By Emma Trincal

New York, Feb. 6 – Bank of Montreal’s 0% buffered bullish enhanced return notes due March 29, 2018 linked to the Russell 2000 index, despite a “small” buffer, provide enough cap and leverage to satisfy the appetite of a growing number of bulls attracted to the small-capitalization market, which has rallied for a year.

The payout at maturity will be par plus 250% of any index gain, up to a maximum redemption amount of $1,137.50 per $1,000 principal amount, according to an FWP filing with the Securities and Exchange Commission.

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

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he was “impressed” by the offering even if the product does not correspond to what he usually shops for.

Investment incentive

“We wouldn’t normally look at that at all. It’s a short-term note and we invest long-term. But it’s so well done. It’s a really good one we could utilize for some clients,” he said.

Among those “clients,” he cited “those with no exposure to small-cap and who need to have one,” or investors who “did well last year” in the asset class.

The Russell 2000 index rose by more than 21% in 2016.

“You can dip your toe into it,” he said about the first group. For investors already long the benchmark, he recommended selling a portion of their position, “maybe a third,” and move it into the notes, he said.

Taxes

“I can’t find anything wrong with this product. I love the bank. I love the fee. I love the leverage. I love the cap,” he said.

The fee is 0.43%, according to the prospectus.

“If I had to look for something, it would be the taxation. This is not a note for a taxable account. It would have to go into a tax-deferred or tax-free account, probably an RIA,” he said.

That is because investors in buffered notes tend to pay income tax rather than capital gains on their profit, he said, even if the guaranteed portion is as small as 5%.

The prospectus indeed stated that it was the case.

“As long as the buffer is not geared and you are guaranteed not to lose 100% of your money that’s usually how it goes,” he said.

“But if taxes are your biggest issue in life, you don’t have a lot to complain about,” he said.

Cap

The potentially high return was compelling enough to offset the small size of the buffer.

“We usually strive for uncapped. The uncapped structure works like a charm.

“This one is capped but at least I’m not giving away the farm on the upside.”

Investing in the Russell 2000 index can yield big gains, he said. In 2013 for instance, the benchmark was up nearly 40%.

“But on average, I doubt that I’m going to have disappointed clients if they can make 13.75% after roughly one year,” he said.

Investors would easily hit the cap if the Russell 2000 index grew by just 5% a year. The 13.75% maximum return over the 13-month tenor represents on an annualized compounded basis a 12.65% gain.

“You have a great opportunity to get a double-digit return,” he said.

Bullish market

A second reason making Kalscheur optimistic about the product was his own view on the small-cap sector.

“There is a new administration, lower taxes, less regulation, a new interest rate cycle,” he said.

“These are macro things I can’t control.

“But it looks very bullish to me for the small-business sector.

“Every time you have a lower tax rate and fewer regulations, it helps the little guy.

“So I’m pretty bullish on the Russell.”

Despite the “small buffer” size, Kalscheur said the notes still offered a good balance between risk and profit.

“If you buy it expecting the buffer to protect you completely, this is not the right product,” he said. “I wouldn’t put an old lady into that, that’s for sure.

“But I like the notes very much from a structural standpoint and as an asset class.

“It’s a good offering.”

For allocation’s sake

Carl Kunhardt, wealth adviser at Quest Capital Management, also said he found the product compelling as an asset allocator.

“The Russell is more volatile than the plain-vanilla S&P but going back to a normal asset allocation, I’m always going to have small-cap in the account,” he said.

“This gives me the exposure.”

When choosing a note, Kunhardt compares it with the benchmark directly or the fund that replicates the index.

“Can I get past the fee? Yes.

“Can I get past the Russell? I have to be in it.”

Kunhardt said he missed the rally in the Russell 2000, adding that he will add to his position.

“It did particularly well last year. I’m not chasing it. But based on the political environment, if Trump does the things he said he wants to do, without looking at his values – I’m not getting into that – it’s a good climate for business, in particular, small businesses.

“So yes, I’m more bullish on small-caps and the economy than I was three months ago.”

Up, down

Kunhardt was happy with the product’s upside potential.

“The cap is irrelevant. I have a potential 13% on, let’s call it one year. All I have to do is post a positive 5% on the benchmark,” he said.

Having a buffer, even of a small size, was always good to have in any structure.

“The market goes down, it’s only 5%. OK. But if the Russell is down 10%, it’s much easier to tell a client you’re down 5% than down 10%.

“You’d always like a larger buffer.

“But you have to be realistic. This is a 13-month. There is no practical way the bank can give you more and hedge it on such a short period of time.”

BMO Capital Markets Corp. is the agent.

The notes will price on Feb. 23 and settle on Feb. 28.

The Cusip number is 06367TSS0.

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