Bank of Montreal, Barclays to price defensive notes with limited upside tied to MSCI EAFE ETF

By Emma Trincal

New York, Oct. 1 - Two issuers announced deals linked to the same exchange-traded fund, exemplifying a recent trend, sources observed: For more protection, investors are willing to forego a significant portion of the upside.

One of the upcoming deals is Bank of Montreal's 0% autocallable cash-settled notes with step-up call price due Oct. 31, 2016 linked to the iShares MSCI EAFE index fund. It is a three-year autocallable product with annual call dates and an 80% final barrier.

The underlying fund, which trades on the NYSE Arca under the ticker "EFA," tracks the equity performance of developed countries excluding the United States and Canada.

On any of three annual call dates, if the fund's share price is greater than its initial share price, the notes will be called, according to a 424B2 filing with the Securities and Exchange Commission.

The call return will be 7.25% on Oct. 28, 2014, 14.5% on Oct. 27, 2015 and 21.75% on Oct. 26, 2016.

If the notes are not called, the payout at maturity will be par if the fund falls by up to 20%. Investors will share in losses if the final price is less than the 80% trigger level.

The second product is a buffered note with unleveraged return and a cap.

Barclays Bank plc plans to price 0% buffered Super Track notes due Oct. 15, 2015 linked to the iShares MSCI EAFE index fund. At maturity, if the ETF performance is greater than zero, investors will get the index return up to a 12.35% to 13.35% cap to be set at pricing, according to a 424B2 filing with the SEC.

If the ETF's return is zero to negative 20%, the payout will be par. If the ETF's return is less than negative 20%, investors will lose 1% for every 1% that the ETF declines beyond 20%.

Emphasis on protection

"Both deals are very different, but they share one thing: a decent level of protection but returns that are not very high," said Tom Balcom, founder of 1650 Wealth Management.

"I think we're seeing more of those defensive deals out there. There's definitely a trend towards more protection even if it means sacrificing some of the upside. There are not that many ways to offer downside protection other than extending maturities. With interest rates being as low as they are, it's difficult to make these terms very juicy."

The Barclays deal is designed for long-only investors who want exposure to the market but with much less downside risk, he noted.

"They both have the same 20% protection level, but the Barclays offers a better type of protection. If the fund is down 25%, which one of the two products would be the most harmful? Obviously the autocallable one with the barrier would be the worst," Balcom said.

"The Barclays is a good option for investors who think the market could potentially be down in two years but still want the exposure. If you anticipate a potential pullback, you're obviously better off with the buffer.

"The other product is more like a yield play even though the maximum return is less.

"They both have pretty low caps, one at 7.25% a year, the other at less than 7%."

Donald McCoy, financial adviser at Planners Financial Services, said that he noticed a similar trend. Some investors are increasingly attracted to structures that emphasize the downside protection, often to the detriment of the upside.

"It's typical of trends to kind of overstay their welcome. Just when the overall market represents a good value in equities, people are still looking for protection on the downside," he said.

Moving parts

Both deals are designed for investors with limited upside expectations, said McCoy. But one at least offers a more effective way to reduce risk.

"There are a lot of moving parts in the autocallable one. You have a 20% barrier at maturity and a potential 21.75% upside at the end of the three years. This is for someone who thinks the market is going to trade in a minus 20% to plus 20% range over the next three years. But this protection is limited. You're not getting any protection if the fund goes further down. If the EFA is down 50%, you lose 50%. They only give you a 20% barrier. It's an all-or-nothing on the downside protection," he said.

"The upside, however, is more straightforward: If it's up, you know what you're going to get ahead of time.

"The other deal has a buffer, and the upside is also limited by a cap. The most I'm going to make is roughly 6.5% each year for the next two years. This is not how the market works. You'll get a really good year then something completely different.

"If people have modest expectations from the market, these aren't bad choices for them. It will probably help them sleep at night. You have low expectations, and if the market goes much higher than your cap, you have to be willing to live with that. There will always be demand for these types of deals because you always have people with fear and low expectations."

Rationale

There are various reasons why investors would be willing to cap their upside in the high single digits, said Balcom.

"The autocall targets the yield replacement investor who worries about interest rates as there is a risk of principal decline for bond investors in a rising risk environment. It gives you a predefined return under certain conditions," he said.

"The autocallable will give you a shorter maturity if you get called, and in a flat market, you can easily outperform the underlying."

Another factor would be the desire to do better than a bond portfolio while mitigating the downside risk, said McCoy.

"Many investors look at the poor returns on their bond portfolios and see much better returns in equities. They forget about the risk," he said.

"It's our job, as financial advisers, to keep them balanced and get them not to go overboard one way or the other.

"My job is to continue to educate them about risks.

"Some people are also worried about rising interest rates. Maybe you take some of your bond exposure and go with a very defensive, equity-based note like this one. You still have some protection even if it's not full protection. Over two years, you have a 20% buffer. It reduces the risk while still giving you some equity exposure."

The Bank of Montreal autocallables (Cusip: 06366RRM9) are expected to price Oct. 28 and settle Oct. 31. BMO Capital Markets Corp. is the agent.

The Barclays notes (Cusip: 06741TP43) are expected to price Oct. 9 and settle Oct. 15. Barclays is the agent.

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