BMO’s booster notes with barrier on MSCI EAFE fund, Euro Stoxx index to offer ‘fair’ trade

By Emma Trincal

New York, Aug. 5 – Bank of Montreal’s 0% booster notes with barrier due Aug. 31, 2022 linked to the lesser performing of the iShares MSCI EAFE exchange-traded fund and the Euro Stoxx 50 index compensated investors for the dispersion risk associated with the worst-of payout as well as the non-payment of dividends because the product offered many benefits to investors, financial advisers said.

If the lesser performing underlying asset increases above the booster percentage, which is 136% of the initial level, the payout at maturity will be par plus the return of the lesser performing asset, according to an FWP filing with the Securities and Exchange Commission.

If the lesser performing asset increases but by less than the booster percentage, the payout will be par plus 30%.

If the lesser performing underlying is unchanged or declines but not by more than 30% of the initial level, the payout will be par.

Otherwise, investors will lose 1% for each 1% decline of the lesser performing underlying from its initial level.

Correlation

One of the main risks with worst-of is when the underlying assets have a low or negative correlation as it increases the odds that one of the two may decline, said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

“It’s not the case here,” he noted.

“There is a lot of overlap between the two. The EAFE is very Europe-heavy. None of them had a stellar performance but they’re highly correlated, which is a good thing.”

The coefficient of correlation between the two underlying assets is 0.93 with 1 being perfect correlation.

The digital-type of payout made the risk of dispersion even less critical, which is why, even a lackluster performance, could benefit investors.

“When you have a minimum return of 36% if the lesser of the two is just positive, we don’t need to have great returns. All you need is having positive return.”

No cap

The booster allowed the notes to outperform in a sideways market finishing flat or negative. It also did not penalize the bulls.

“The beauty of the product is also the no-cap. Should we have a massive rally, you’re still getting the return of the worst-of. So you’re not missing on anything in a bull market except for the dividends,” Kalscheur said.

Euro Stoxx

The 30% “soft” protection made this adviser a little bit more cautious. Part of it was his view on the Euro Stoxx 50 index.

“The performance of the Euro Stoxx 50 has been terrible. It’s a very concentrated portfolio with only 50 stocks. Not only that...It over-allocates to underperforming sectors and under-allocates to growth. Technology in the Euro Stoxx is half of what it is in the S&P. On the other hand, it’s overweight utilities where the performance is lower.”

The technology sector has a 10.77% weighting in the Euro Stoxx 50 index versus 21.82% in the S&P 500 index.

Utilities make for 5.17% of the Euro Stoxx 50 and 3.34% of the U.S. large-cap index.

Barrier

Kalscheur looked at back-testing data that dates back to 2001 for the EAFE index and 2002 for the Euro Stoxx 50.

He found that during those timeframes and over three-year rolling periods, the chances of breaching the 70% barrier was 3.48% for the EAFE and 6.4% for the Euro Stoxx.

“Since we’re talking about the worst of the two, the probabilities are higher. I’m not sure what they are...probably somewhere between 6.4% and 10%,” he said.

“It’s a pretty big number and it bothers me a little bit. But it won’t kill the deal for me.”

August pullback

Another factor that may lower the risk is the pricing date of the notes set for Aug. 29, according to the prospectus.

“If the market sells off in August, you’re starting at a very low point. If you’re already down, it will be even harder to be down 30%,” he said.

He was not talking out of context. On Monday, the Dow Jones industrial average plunged 767 points to 25,718, a 2.9% drop, amid the escalation of the trade war between the United States and China. It was one of the most severe one-day drops in the index ever.

Trade-off

“You’re giving up healthy dividends. That’s not negligible,” he said, pointing to the 3.10% dividend yield of the EAFE ETF and 2.88% for the Euro Stoxx.

“You’re also getting exposure to the worst-of. But the two are highly correlated.

“I would be perfectly happy to have my international equity exposure making at least 36% over three years.

“I’m not crazy about the Euro Stoxx 50. But the terms of this deal are really, really good.”

Jerrod Dawson, director of investment research at Quest Capital Management, agreed.

“It’s a pretty reasonable trade-off,” he said.

“You get the barrier and you get the kicker if the worst underlier is not above 12% a year. If it is, you get the full upside,” he said.

Dawson said he likes to evaluate structured notes based on a comparable long-only position.

“It’s not like being invested in two international ETFs. But they’re pretty correlated. So yes, you have the worst-of. But the worst-of is compensated for with the barrier. You wouldn’t have a barrier if you were long the market.

“I think, relative to a simple international ETF, it’s a good alternative.”

The barrier was not the only compensation for the risk induced by the worst-of.

“You get the kicker. As long as the return is positive you are guaranteed at least 36% of the worst of.

“That’s a pretty fair trade.

“The biggest risk is if the correlation decouples. One goes up, the other goes down. That’s the risk. But it’s a risk you’re going to have anytime you choose an investment vehicle and hedge it.

“So the worst-of doesn’t really bother me too much.”

BMO Capital Markets Corp. is the agent.

The notes will settle on Sept. 4.

The Cusip is: 06367WMY6

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