BMO’s two deals tied to basket of funds picked by Raymond James may prefigure new retail push

By Emma Trincal

New York, July 5 – Bank of Montreal priced two deals linked to a basket of closed-end funds selected by Raymond James & Associates in an effort to put a popular retail play into a simple note format, according to sources. The deals, identical in terms – both mature on July 16, 2018 and are tied to the same basket – priced at $6.44 million and $2.33 million respectively on June 23.

The collaboration between Raymond James and BMO is a strong one.

The most successful trades from this partnership are the blockbuster deals issued by BMO twice a year linked to Raymond James Analysts’ Best Picks in December and January.

Basket remake

The use of notes linked to a basket of funds, in particular closed-end funds, is more unusual even though it has been done last year in an index format.

Bank of Nova Scotia priced two deals in February 2016 totaling less than $14 million linked to the Raymond James CEFR Domestic Equity Total Return index, an index of 25 closed-end funds picked by Raymond James.

This time, the underlying is a basket, not an index.

“It’s more of a short-term, static investment, something designed for specific opportunities,” said a sellsider. The basket, like the index, has 25 components.

Another factor may be practicality.

“Closed-end funds are notoriously difficult to trade, get a hedge off, so [Raymond James] is moving in the same direction, same market but with a basket this time because using an index is a hassle,” said a market participant.

Retail space

Closed-end fund are a mostly distributed to individual investors. Retail represents 75% of the U.S. closed-end fund market, according to Eric Boughton, portfolio manager at Deschutes Portfolio Strategies, an investment firm with $200 million of closed-end funds in assets.

He defined “retail” investors as non-reporting holders.

Last week’s deals were sold to multiple retail clients, the sellsider said.

The “Best” series

The main idea, according to this source is to “replicate” the success of the “Best Picks” formula, as clients of Raymond James want exposure to the well-established equity research brand of the firms.

As an example of the size of the “Best Picks” deals: Bank of Montreal priced in January $310.24 million of one-year notes linked to Raymond James Best Picks for 2017. It was the second tranche. The December issue totaled $250 million.

Less participation

Last week’s pair of deals featured simple terms: investors participate in the basket returns and in the distribution. The participation for the $6.44 million deal was 97.8% and for the $2.33 million deal was 99.05%. Investors needed the basket to finish at or above 102.25% and 100.96% of its initial level, respectively, to break even.

The notes pay interest quarterly based on the underlying funds’ distribution.

The difference between 100% and 99.05% represents the costs and fees and the deal with 97.8% participation has a further 1.25% deducted for the commission paid to Raymond James for distribution.

An industry source explained that the fee structure derived from the nature of the product.

“It’s basically a pass-through one to one. There is no optionality. The only way the firm or its brokers can receive compensation is by decreasing the participation rate,” he said.

“It’s a one-year. There is funding. Maybe Libor flat. At the same time, the bank has to make it work. They have to buy the assets. There are commissions involved. They have to cover the costs for hedges. There are operational costs, legal costs.”

For investors buying a “package product” is more cost efficient, he said.

“If you’re an individual client, you don’t get institutional pricing...Buying all those closed-end funds would cost you an arm and a leg.”

Opportunities

Shares of a closed-end fund trade at market price, which may be a discount or premium to the net asset value, according to the prospectus.

This pricing inefficiency generates opportunities for investors who would buy at a deep discount or sell at a premium,” said Deschutes’ Boughton.

“My guess is that the Raymond James selection is probably based on identifying discounts,” he said.

His firm, which manages a portfolio of closed-end funds of which half is the firm’s fund of closed-end funds, applies this strategy.

“We purchase funds with very large discounts and sell out of them when the discount trade close to NAV,” he said.

“We would purchase at a 16%, 17% discount and sell at 12% or 13%.”

Closed-end funds display “fairly readily identifiable” patterns allowing a savvy analyst to know when a fund is prime for the narrowing of the discount based on historical trends, he added.

Fixed-income alternative

A source said that the discount to NAV play was “one facet” of the strategy employed by Raymond James.

“Their portfolio is designed for income, I can see that because several of the funds pay larger distribution,” said Boughton after reading the list of the 25 components.

Investors looking for yield outside of the fixed-income spectrum may also like closed-end funds as they present very little exposure to interest rate risk, he noted.

“Historically the discounts to NAV have not responded to changes in interest rate,” he said.

But using the notes just for yield was probably unwise.

“This basket is a diversified pool of global equity. You have not only credit risk, since it’s a note, but also equity risk.

“Basically you own stocks. The fact that they pay a distribution doesn’t really matter. You’re exposed to the market. It’s not the same as buying a bond just like dividend stocks are not the same as bonds.”

The basket

The basket consists of 25 unequally weighted closed-end funds selected in May by Raymond James & Associates, Inc.

The underlying funds are Morgan Stanley Asia Pacific Fund, Inc., Liberty All-Star Growth Fund, BlackRock Enhanced Equity Dividend Trust, BlackRock Energy and Resources Trust, BlackRock Science and Technology Trust, John Hancock Financial Opportunities Fund, Nuveen S&P 500 Buy-Write Income Fund, BlackRock Enhanced Capital and Income Fund, Inc., Duff & Phelps Global Utility Income Fund Inc., Eaton Vance Tax-Advantaged Global Dividend Fund, Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund, Eaton Vance Tax-Managed Diversified Equity Income Fund, First Trust Dynamic Europe Equity Income Fund, First Trust Enhanced Equity Income Fund, Gabelli Dividend & Income Trust, Guggenheim Enhanced Equity Income Fund, John Hancock Hedged Equity & Income Fund, Voya Global Equity Dividend and Premium Opportunity Fund, Nuveen Core Equity Alpha Fund, Lazard Global Total Return & Income Fund, Inc., Morgan Stanley Emerging Markets Fund, Inc., Royce Global Value Trust, Cohen & Steers Quality Income Realty Fund, Inc., Tekla World Healthcare Fund and Tri-Continental Corp.

The initial share price of each fund will be determined over the 10 averaging dates around issuance, from June 23 through July 7.

Likewise, the final share price will be determined over 10 valuation dates from June 27, 2018 to July 11, 2018.

BMO Capital Markets Corp. is the agent.

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