BMO’s enhanced return notes linked to Russell 2000 show deep buffer, but cap disappoints some

By Emma Trincal

New York, July 17 – Bank of Montreal plans to price 0% buffered bullish enhanced return notes due July 31, 2019 linked to the Russell 2000 index, according to an FWP filing with the Securities and Exchange Commission.

If the index return is greater than zero, the payout at maturity will be par plus 150% of the index return, subject to a maximum return of 15%.

If the index suffers a loss of between zero and the buffer percentage, the payout will be par. If the index loses more than the buffer percentage, investors will lose 1% for every 1% that the index declines beyond the buffer.

The buffer percentage will be between 17.75% and 20.75% and will be set at pricing.

Good deal

“For someone who likes the Russell and who is not too bullish, this is a pretty good deal over two years,” said Scott Cramer, president of Cramer & Rauchegger, Inc.

“The index doesn’t have to be that positive to get you to the maximum return.

“Clearly if you’re unbelievably bullish on the Russell, you may get capped out and you don’t want this trade.

“But if you’re moderately bullish or if you think the market will be relatively flat, this is just the downside protection that you want.”

Cap, buffer

An annual growth of 4.90% would enable investors to claim the 15% cap over two years. The cap on an annualized compounded basis is 7.25%.

“Even if the index is up 12%, you get your 15% and you can outperform,” he said.

The most obvious value of the product is the downside protection, he said.

“This note gives you some potential upside with some downside protection. And what this type of protection does is to allow you to be wrong. If the market is down, you can be wrong up to a point.”

Good basis

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he is “disappointed” by the deal.

“It’s a good issuer, a good index, a very low fee ... I thought this should be a very good deal. But unfortunately I don’t think it is because the terms aren’t good,” he said.

The fee is 0.25%, according to the prospectus.

Cap

Kalscheur’s main objection is the cap.

“I like a little bit of leverage, but this cap is too low,” he said.

“If I’m going to take equity-like risk, I want equity-like returns.”

A 7% per year positive return is not sufficient, he said. The S&P 500 index is already up 10% for the year and the Russell 2000 has gained 5%, he noted.

“We’re only up 5%, but it’s mid-July. I can’t imagine small caps being up only 7% for the year.”

Bullish

For Kalscheur, “equity-like returns” means “double-digit” gains.

“If I don’t get double-digit returns, I have alternatives. I can buy closed-end funds or high-yield bonds.

“I just think the cap is not exciting. The buffer is very good on a short-term note, but since my upside is so limited, I can also limit my downside and do better just buying bonds.”

Part of Kalscheur’s disappointment has to do with his view on the Russell 2000.

“Statistically speaking, I don’t see how the Russell would yield single-digit returns. I see it more trading in a 15% to 30% range.

“I’m confident in the Russell. It’s the small caps, the less-regulated part of the economy, the sector that will benefit the most from economic reforms. I’m not betting on a health-care reform or tax bill soon, but I certainly don’t see single-digit returns in this high-growth section of the stock market.”

The notes do not fit into Kalscheur’s portfolio in general. He explained that he prefers longer-dated notes.

“I’ll take a two-years but with a higher cap and less leverage because I’m confident in the market, in the U.S. economy. I’d like to see it run.”

Another deal

Separately, Bank of Montreal announced a very similar deal, which allows advisers to compare the two notes.

The second deal has the same maturity date, underlying index and fee.

The only differences are as follows, according to a separate FWP filing:

• Leverage is two times instead of 1.5 times for the first product;

• The cap is higher at 17.8% (midpoint of a 15.8% to 19.8% range) versus 15%;

•∙The 10% buffer is lower by nearly 10 percentage points if one assumes a 19.25% buffer on the first deal at midpoint again; and

•∙The annualized compounded cap is 8.55%, slightly more than 7.25%.

First is best

“I was not initially excited by the first one. But the second one with the higher leverage doesn’t do it for me either,” said Kalscheur.

“I buy notes for the downside protection and a better-than-average opportunity to outperform.

“The cap they give you also leaves too much on the table. And you lose a substantial amount of downside protection.

“I’d rather have a lot more of the top end and less leverage.

“None of those deals can get me excited.”

Without hesitation, Cramer said he prefers the first deal.

“I’ll take the buffer. With the second one, you get a 10% cap versus 7.5% ... trading 2.5 points more on the upside for 10 points less in the buffer. It’s a no-brainer.

“I’m a conservative guy. I’d rather have the protection on the downside. That’s why we do those things.”

BMO Capital Markets Corp. is the agent for both offerings, which will price July 26.

The Cusip number is 06367TZL7 for the first deal and 06367TZM5 for the second.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.