BMO’s absolute return notes tied to S&P 500 offer attractive four-year play, buysiders say

By Emma Trincal

New York, May 14 – Bank of Montreal’s 0% contingent risk absolute return notes due May 31, 2022 linked to the S&P 500 index can appeal to investors in a wide range of market conditions, financial advisers said.

“I love it,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

If the index finishes above the initial level, the payout at maturity will be par plus the index gain, according to a 424B2 filed with the Securities and Exchange Commission.

If the index falls by up to its 75% barrier level, the payout will be par plus the absolute value of the return.

Otherwise, investors will lose 1% for each 1% decline.

Upside

“There is no issue with the upside. I’m not capped. The only downside to the note is the loss of dividends. But with 1.85% I’m not losing much of anything,” said Kunhardt.

The S&P 500 index has a dividend yield of 1.85%.

“To me it’s a wash. You never get the dividends with any note anyway. And in this case, it pays for the absolute return and the barrier. If you only look at the upside, you’re not getting anything less than what you would get with the index.”

Downside

But the structure was even more interesting in a down market under the barrier limits.

“The downside...that’s what makes the note,” he said.

“I have two things: a safety net of 25% and 25 points of potential alpha.”

The S&P 500 index was unlikely to drop more than 25% over a four-year period, he noted, citing statistical data.

“That makes that safety net even more valuable. If I’m down by less than 25%, I’m getting paid.

“Even if I breach the 25% barrier: I’m not any less than being long the index, again ignoring the dividends.

“I may lose the dividends. That’s an opportunity cost. But on that first 25%, I’m getting the absolute return. That to me, more than offsets the cost,” he said.

Absolute gravy

The four-year note carries a 1.6% fee, according to the prospectus.

“Even the fee, which is 40 basis points per annum, is not particularly expensive given the downside you’re getting.”

“The way this note is structured, even without the absolute return it would have been interesting.

“You put the absolute return on it. It’s a no-brainer,” he said.

Market analysis

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said the value of the notes should be assessed based on different market scenarios.

“It’s a pretty reasonable note. The benefits vary based on what the market is doing,” he said.

“It does have protection but up to 25%. If the market sells off 25% or more in the next four years, which is definitely possible, you lose the protection. That’s the tail risk.”

Chisholm noted that the non-payment of dividends will cost investors approximately 7.5% over the life of the notes.

“It’s not negligible. I guess if the market is up a lot, it’s OK. It’s more of a concern in a flat market especially if it trends up at a moderate pace.

“If it’s down slightly it certainly benefits you,” he said.

Hedging the tail

Overall the bulk of the risk would be a bear market.

What the notes do not really “cover” is the “tail risk” scenario in which the index drops more than 25%, he explained.

“The consensus is that we’re due for a recession. Four years is a long time. We should expect one in the next four years,” he said.

A breach of the 75% barrier at maturity would guarantee a steep loss of at least 25%. But such a risk can be hedged, he said.

Buying a 25% out-of-the money put – the equivalent of a protection after a 25% index decline on a two-year contract would cost 3.9%, or approximately 4%, he noted.

Four-year contracts are not available on listed options.

The cost of hedging the notes would then be 2% a year.

“It’s right around the cost of the dividends. It’s affordable,” he said.

“In that context it’s not so bad. If you can overlay the notes with a put, it’s quite attractive.

“You get absolute return up to a 25% drop and then you’re protected. No cap on the upside.

“Having a put to hedge the tail risk is a good way to look at this trade.”

BMO Capital Markets Corp. is the agent.

The notes will price on May 25 and settle on May 31.

The Cusip number is 06367T5S5.

© 2015 Prospect News.
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