Bank of Montreal, Barclays plan non-leveraged notes with caps but more defensive buffers

By Emma Trincal

New York, Jan. 17 - In a move toward more simplicity and more protection, some issuers have recently offered notes with no leverage but more attractive buffers, sources noted.

By eliminating the leverage while maintaining a cap, those products are designed to be more defensive. They also tend to be easier to understand as they deliver a return on a one-for-one basis, the sources said.

"These are pretty vanilla notes. You're buffered and you're capped," said Steve Doucette, financial adviser at Proctor Financial.

And there is no leverage, he added.

"There are times to make leveraged bets and there are times to be cautious. Right now, I think it's more of a time to be cautious," said Kirk Chisholm, principal and wealth manager at NUA Advisors.

Bank of Montreal and Barclays Bank plc have announced products that fit into that category.

Two deals

Bank of Montreal plans to price 1.4% to 1.8% buffered bullish coupon-bearing notes due Jan. 29, 2016 linked to the iShares Dow Jones U.S. Real Estate index fund, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable annually.

The payout at maturity will be par plus any gain in the fund, up to a maximum payout of 20%. Investors will receive par if the fund falls by up to 15% and will be exposed to any losses beyond 15%.

"If somebody is still leery about investing in real estate or in the equity markets, that might make sense for that type of investor looking for a bit of protection. However, if there were times for that type of investment, it would have been a few years back," Chisholm said.

Separately, Barclays announced plans to price 0% buffered Super Track notes due Feb. 2, 2015 linked to the iShares Russell 2000 index fund.

The payout at maturity will be par plus any fund gain, up to a maximum return of 17.7% to 20.7%. The exact cap will be set at pricing, according to a 424B2 filing. Investors will receive par if the shares fall by up to 20% and will lose 1% for every 1% decline beyond 20%.

While the first note has a longer tenor, both products offer a buffer instead of the more common barrier, sources noted, adding that buffers are better tools for risk mitigation than barriers comparable in size.

"In this environment, focusing on risk management is the most important thing," Chisholm said.

"Remember the Warren Buffett rule number one: don't lose money. Rule number two: see rule number one.

"It's particularly true today. There are lots of potential black swans out there."

But for very bullish investors, the cap may be too low, and for the moderately bullish view, leverage may be lacking.

Not for bulls

Chisholm, who is bullish on real estate, said that he would not invest in the first note.

"Real estate from my perspective started to do well in the past six to 12 months. There's been a change in the trend with prices moving up and banks slowly getting rid of the foreclosures on their balance sheets," he said.

"Record low mortgage rates will continue to support the sector, pushing up real estate prices. I see this bullish trend continuing for some time. That's why I would be hesitant to invest on three-year notes like this one. A 20% cap is not a whole heck of a lot for three years."

In the last two months, the U.S. real estate fund has gained 9.5%. It is up 13.5% since June 2012.

"I'm pretty bullish on real estate for the next three to five years. People have started to see the value. Companies like Blackstone have acquired real estate companies because they see value. It's starting to really pick up. I would suspect that in the next three years, the index would be up by more than 20%. So obviously, this cap is not enough for me," he said.

Chisholm said that he would not invest in the index fund directly, preferring to select the right opportunities in the sector via equities.

"The Blackstone group is doing pretty well with real estate. Home Depot is another example. Suppliers to anybody building houses should do well: painting, lumber. I would also look at a few REITs that can take advantage of that trend, with a focus on residential real estate, which is where I'm the most bullish."

With its small-cap exposure, the second deal with was more appealing to Chisholm in terms of risk-adjusted return.

"If I was to seek exposure to small caps through the index, I would think it's a decent way to do it given the approximately 20% cap in line with the 20% buffer, especially for somebody who is a bit risk-averse," he said.

"Small caps offer more value than large caps right now, so the exposure makes sense, although I would probably not do it through the index."

He said he liked the two-year small-cap notes better than the three-year real-estate fund-linked product due to its shorter maturity.

"It makes a difference. Three years is a long time. Look at the last three years and what happened to the market. Today, a lot can happen in three months, even in one month," he said.

Fixing the upside

Steve Doucette, financial adviser at Proctor Financial, comparing the two products, said he would pick the real estate fund product, not because of its structure but because of the market theme.

He noted that the notes tied to the real estate fund offered about 5% in additional return from the coupon.

"On the first one, the cap is not 20%; it's 25% because of the interest. That's a three-year note, so 8% a year is the best you can do. With the other one, your annual return is 10% maximum," he said.

Despite the difference, Doucette said that he would prefer to invest in the REITs product at this point.

"If I had to choose between the two, I would pick the real estate index versus the small-cap stock index.

"Stocks lead you out of a recession in a bearish market. Stocks are a leading indicator. Real estate is a lagging indicator.

"I'd probably go to real estate. I wouldn't cap myself at an 8% return per year though. If I chose the real estate deal, I would give up the coupon so I can get a better return.

"I assume the coupon would be taxed as ordinary income, which would be another reason to give it up. Instead I would increase the cap," he said.

For Doucette, a competitive buffer for a bullish investor may be too high a price to pay for protection.

"I might give up a little bit of the buffer. If stocks are down, real estate might continue to pull. I would lower the buffer to 10% and try to get more return off the top end," he said.

BMO Capital Markets Corp. is the agent for the notes linked to the iShares Dow Jones U.S. Real Estate index fund. The Cusip number is 06366RLA1.

Barclays is the agent for the notes tied to the iShares Russell 2000 index fund. The Cusip number is 06741TMW4.

Both products will price on Jan. 28 and settle on Jan. 31.

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