BMO’s contingent 10% cash-settled autocalls on oil, gold funds designed for savvy investors

By Emma Trincal

New York, June 15 – Bank of Montreal’s 10% autocallable cash-settled notes with conditional interest payments due June 30, 2021 linked to the lesser performing of the SPDR S&P Oil & Gas Exploration & Production ETF and the VanEck Vectors Gold Miners ETF are not for the faint of heart, sources said.

Interest is payable quarterly at an annual rate of 10% if each underlying component closes at or above its 68.5% coupon barrier level on the observation date for that quarter, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par if each component closes at or above its initial level on any review date beginning on Dec. 26, 2018.

The payout at maturity will be par unless either fund finishes below its 68.55% trigger level, in which case investors be fully exposed to any losses of the worse performing fund.

The funds

Gold has not been in favor, sources said. Since the February pullback, equity markets have regained momentum but gold moved the opposite way. Since the VanEck Vectors Gold Miners fund is correlated to the price of gold, the value of the fund has also underperformed the overall market.

The Gold Miners ETF has dropped nearly 4% this year while the S&P 500 is up 2%.

On the other hand, the SPDR S&P Oil & Gas Exploration and Production ETF has rallied, gaining 6% for the year and outperforming the equity benchmark.

“Are those two funds often used together? We’ve seen a few but not many,” a market participant said.

“Are they correlated? Yes, in that they’re both commodities-based.”

He went on joking: “You also have the letter “X” in their acronyms so in that way they’re correlated you could say.”

The SPDR S&P Oil & Gas Exploration & Production ETF and the VanEck Vectors Gold Miners ETF are listed on the NYSE Arca under the symbol “XOP” and “GDX,” respectively.

Barrier

The notes must have been designed for an investor aiming for a 10% coupon as a starting point, he said.

“It seems like somebody said: I want this term, I want this 10% coupon. What barrier do I get? That’s how you come up with this weird number...a 68.55% barrier.”

Although “weird,” as a number, the barrier offers a fairly “reasonable” downside protection, he noted, allowing for the worst-performing asset more than 30% in price decline in the three-year timeframe.

The low barrier was made possible in part as a result of the correlation level between the two funds.

Their correlation coefficient is 0.26, or near zero, which indicates that there is near to zero relationship between the two underlying.

Comfortable with risk

“The very low correlation is more risk and it increases your premium. This is probably why the coupon is so high,” he said.

For savvy investors with a good understanding of the two markets, the notes provide above-average income potential. While too risky to replace a fixed-income instrument, collecting the coupon over several periods was highly probable due to the low coupon barrier level.

“If you are prepared for the risk and have an opinion on the two and you think they’ll stay above the barrier, why not?”

The structure offers three months of call protection, which he viewed as an advantage, although not a significant one.

“It’s always better to have that than taking the risk of getting called after only three months,” he said.

“But in reality, it doesn’t make a whole lot of difference when you go from three to six months. If you went from six months to a year then yes, it would be significant. In that case you would probably have a little bit less protection or a lower coupon.”

Worst-of structure eyed

Donald McCoy, financial adviser at Planners Financial Services, said the notes were too risky for his clients.

His first objection was one he has with most worst-of deals.

“It’s very hard to explain to a client. Any worst-of is hard to explain.

“And then there’s the call. You don’t know how long you’ll be holding the notes for...You may or may not get called...

“OK, stay with me on this Mr. Client...it’s going to take a while to explain,” he said.

Uncorrelated assets

One main risk with worst-of structures is the dispersion between the two underliers. This particular note showed a high level of risk from that standpoint, he said.

“Both underlying are fairly uncorrelated,” he noted.

In 2016, GDX “rose much more” than XOP. In 2013, GDX “dropped a lot more,” he said, using the symbols to designate the funds.

In 2008 and 2015, XOP underperformed significantly, “down much more” than GDX.

“In 2013 however, GDX “dropped dramatically,” losing 55% for the year.

This year, the two ETFs are “diverging quite a lot as well,” he noted.

“They’ve rarely been up or down together or if they are, it’s with big differences in range,” he said.

The exception would be 2009, when XOP and GDX were up 37% and 40%, respectively, and also in 2010 “to some degree,” he added.

Big swings

Aside from dispersion, volatility was another concern as suggested by historical performance.

“With such wild swings it’s very possible to breach the barrier. When you get these kinds of losses like down 55% in one year, even if you’re up the next year you’ve got a lot more climbing to do to finish up,” he said.

For McCoy, this type of structure would be more appropriate without such high volatility.

“Your barrier can be easily breached and your upside is capped by the coupon. It seems like a solution in search of a problem,” he said.

BMO Capital Markets Corp. is the agent.

The notes will price on June 26 and settle on June 29.

The Cusip is 06367T6C9.

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