Bank of Montreal’s bullish leveraged return notes on basket offer straightforward, global play

By Emma Trincal

New York, May 6 – Bank of Montreal’s 0% buffered bullish enhanced return notes due May 31, 2018 linked to a basket containing three indexes and one exchange-traded fund give investors diversified exposure to global equities while scoring above average based on Future Value Consultants’ rating methodology, said structured products analyst Suzi Hampson.

The underlying components are the S&P 500 index with a 40% weight, the Euro Stoxx 50 index with a 30% weight, the Russell 2000 index with a 20% weight and the iShares MSCI Emerging Markets exchange-traded fund with a 10% weight, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 150% of any basket gain, subject to a maximum payout of $1,153.75 per $1,000 of notes.

Investors will receive par if the basket falls by up to 10% and will lose 1% for each 1% decline beyond 10%.

Correlation

“The goal of this product is to offer portfolio diversification,” she said.

One important metric to look at in a basket and even more so in a worst-of note is the correlation between the different basket components or underliers, she said.

“If the correlation is high, you can expect these things to move together. If it’s not, the probabilities increase that the gain generated by one underlying gets suppressed by another, so they would be sort of cancelling each other out.”

The basket components showed a “reasonable correlation,” she said, “going from 65% between the emerging markets fund and the Euro Stoxx to 91% between the S&P 500 and the Russell 2000.

“They’re all positively correlated, so you might as well have one underlying only. This basket is mainly used for diversification across different markets in just one instrument,” she said.

“It’s an easy way to get U.S. and international exposure without having to buy a bunch of ETFs.”

Straightforward

The notes are “very standard,” she said, and should meet the expectations of investors seeking return enhancement with some downside protection, which most of the time, as it is the case here, is priced with a cap on the upside.

The terms appear “well-adjusted,” she added.

“For a two-year product, the 10% buffer is quite appealing. The cap offers a potential of 7.37% a year compounded based on 1.5 times the basket return, which isn’t bad,” she said.

“Meanwhile the 10% buffer is going to lower the risk, as we’ll see in the scores.”

Future Value Consultants, a research firm, scores structured notes based on their risk, return and price using a variety of proprietary scores in order to compare a product to others.

Risk

The firm produces its riskmap, which measures the risk on a scale of zero to 10 with 10 as the highest level of risk possible. This measure of risk is the sum of two riskmap components – market risk and credit risk, both calculated on the same scale.

The notes have a 2.54 riskmap versus an average of 5.28 for the product type.

The notes belong to the leveraged return product type.

Future Value Consultants also compares each score to the average score for all products. This last group encompasses all structured notes recently rated by the firm across all structure types.

Compared to all products, the notes also score above average. The all-product average riskmap is 4.33.

The low risk profile of the notes is a combination of its moderate levels of risk on both the market and credit scales.

The product shows a 2.33 market riskmap versus an average of 4.82 for the product type.

“You can attribute that to the 10% buffer. It’s a good level for that duration. Besides, you’re comparing this note with other leveraged return products, which may not all be capped. Some have barriers, which could create bigger losses,” she said.

At 0.21, the credit riskmap is also lower than the 0.46 average for this category.

The low credit risk was the direct result of the issuer’s creditworthiness, she said.

“They have pretty tight spreads. It helps,” she said.

Bank of Montreal has a five-year credit default swap spread of 51 basis points, she noted.

The average CDS spread for the top U.S. banks right now is around 90 bps, according to Markit.

Return score

The notes also showed superior risk-adjusted return, according to Future Value Consultants’ return score.

This score measures on a scale of zero to 10 the risk-adjusted return of a product, with 10 being the best.

The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets, and high- and low-volatility environments. The return score is calculated based on the best among the five return scenarios, which for this particular product would be the bullish scenario.

The return score is 7.26 versus an average of 6.84 for similar products and 6.36 for all products.

“This note has an above-average risk-adjusted return. And while it has a cap, the score suggests that it also gives investors the highest chances of getting the highest return.

“You get capped out when the basket is up 5% a year. That’s a very moderate kind of growth, one that’s easily achievable.

“Overall this return score tells us that given the risk, this product is offering a decent return compared to what else is available.”

Value

The notes also offered a good value based on the price score, a rating created by Future Value Consultants to measure on a scale of zero to 10 the value of a product to the investor.

This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

At 7.27, the price score is higher than the 6.95 average for the leveraged return category.

“This suggests that a good proportion of the cost has been spent on assets. The issuer has purchased enough options to be able to deliver some good return.

“You get good value for your money.

“The return score and the price score move together. It’s not always the case. But here, both are above average. It’s a good indication that the structure is well-balanced,” she said.

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The notes have a 7.26 overall score while the average for the product type is 6.90.

“This product offers some sort of general appeal. It’s a relatively straightforward payoff. Investors are familiar with it. Leveraged return products are common,” she said.

“Given that we have a lot of similar notes out there, this one is quite competitive.

“It has the particularity of being tied to a very broadly diversified underlying.

“For someone who is looking for diversified equity exposure, someone who is not looking for something too adventurous, those notes offer good value and compare well with what’s out there. It’s quite appealing.”

BMO Capital Markets Corp. is the agent.

The notes (Cusip: 06367TEQ9) are expected to price on May 26 and settle on May 31.

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