BMO’s $247,000 autocall on biotech fund ‘intriguing’ due to barrier type, underlying choice

By Emma Trincal

New York, Oct. 31 – Bank of Montreal’s $247,000 of autocallable barrier notes with a contingent coupon due Nov. 30, 2018 linked to the SPDR S&P Biotech exchange-traded fund made for an “interesting” and “intriguing” trade, sources said, based on the choice of the biotechnology fund as well as the type of barrier used in the structure.

Every month, the notes will pay a coupon equal to 12% per year if the fund’s share price is at least 75% of the initial share price on the observation date for that month, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically redeemed at par plus the contingent coupon if the ETF’s shares close above the initial share price on any observation date beginning in April 2018.

If the notes are not called, the payout at maturity will be par unless the final share price is less than the initial price and the fund has closed below 75% of the initial share price during the life of the notes, in which case investors will lose 1% for each 1% decline from the initial share price.

Daily observation

“It’s an American barrier! I was going to say. Something’s got to give. A 12% on XBI, one year, 75% barrier, six month no call... It looked too good,” a market participant said referring, with “XBI,” to the ticker symbol of the underlying ETF listed on the NYSE Arca.

An American barrier is one that may be breached sometimes during the life of the notes. In contrast the much more widely used “European” barrier is observed just once: at maturity. These terms derive from the types of options contracts built into the notes and the rules of exercise of these options, which are either during the contract term as in an American option or when it expires as in the European option.

Fair

“You would never be able to get 12% for one year with a European barrier. It wouldn’t work. We’ve linked to XBI before. If this deal was based on a European barrier, it would be more like 8%, not 12%,” he said.

That’s because the continuous monitoring of the American style involves more risk of breaching and therefore pays a higher premium in the form of a coupon.

Based on this type of barrier and coupon, he said that the pricing was “fair.”

Volatility was unlikely to be as much a driver as the barrier type behind the double-digit coupon, he said.

The volatility of the ETF at 24% is “not that high,” he noted.

“It’s an index, not a single stock,” he said.

Call protection

This market participant however said his firm avoids those types of barriers for marketing purposes.

“We don’t do American barriers anymore because clients don’t really understand. If you’re showing notes with different observations, people get confused. It pays 8% and this one pays 12%? I want the 12%. So we don’t do that,” he said.

One interesting aspect of the structure, he noted was the “no-call,” which refers to the first six months of the deal during which the autocallable feature is not enabled.

“I think it is a good thing. I am not a fan of autocalls. But if you have six-month no-call that takes risk out of the trade, therefore it takes some of the coupon out of the trade,” he said.

“That’s why they had to put an American option. There was no other way with that type of yield.”

More shots

A buysider said the deal was attractive even though he tends to use European barriers rather than American ones.

Having half of the tenor not “callable” was the first positive trait.

“That’s interesting: American... No call for the first six months... Monthly coupon...You’re guaranteed to play the coupon for the first six months. It’s not a guaranteed coupon but at least you have six shots. For someone who needs monthly income it makes sense,” the buysider said.

Different ETF

The use of the SPDR S&P Biotech fund was also appealing in his view, especially compared to the iShares Nasdaq Biotechnology index fund, listed under the ticker symbol “IBB,” which is another underlying biotech fund commonly used as the underlying for structured notes.

“We tend to trade IBB, which is a little bit more diversified,” he said.

“But Celgene has fallen off of the highs and that’s a concern now.”

Celgene Corp. fell 15% on Thursday after the biotech company reported its third-quarter earnings.

The stock is now down more than 26% from its pre-earnings level.

The iShares Biotech fund (IBB) has a greater exposure to the troubled stock with 8.36% versus only 1.38% for the SPDR ETF.

“I’ll have to take a look at [the SPDR S&P Biotech ETF]. It also has a little more volatility,” he added.

Higher volatility offers the potential for higher coupons. The implied volatility of the SPDR fund is 24% versus 19% for the iShares.

Tenor

“I like the trade,” he said.

“I like the fact that they did a SPDR as opposed to a single-stock or a worst-of. A worst-of with biotech stocks is really a bad idea.

“I like the six month no-call. You’re most likely to get paid 6% over six months. It’s a great trade. Clearly there’s some risk. But tech and biotech have been driving this rally,” he said.

One risk however was the short maturity.

“It would be a safer trade if the principal was at risk further down because with this one-year term, after the no-call, I only have a six-month window to recover if the index is down,” he said.

Calls

Rather than a one-year trade with a six-month period of monthly calls, this investor would look at keeping the six-month call protection period while extending the tenor of the notes to 18 or even 24 months in order to increase the chances a call prior to putting principal at risk. In this alternative structure, the six-month call protection would be maintained. The tradeoff would be extending the maturity for the benefit of having a European barrier.

“We would double the number of call chances by two with an 18 month and by three with 24 months. That’s usually how we like to do these trades. We tend to like European knock-in with extended terms,” he said.

He believed that such an alternative, with a longer tenor, would probably produce the same coupon amount.

“I would have to price it but I don’t think it would modify the coupon by more than 25 basis points.”

The BMO deal however was “interesting” the way it was. Before changing it, this buysider said he would want to examine it further.

“I want to look at the risk-return profile of this because of the American option.

“I think it’s really interesting.”

The notes (Cusip: 06367TJ27) priced on Oct. 26.

BMO Capital Markets Corp. is the agent.

The fee is 0.65%.

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