Bank of Montreal’s booster notes with barrier on EAFE ETF, Stoxx designed to generate alpha

By Emma Trincal

New York, May 7 – Bank of Montreal’s 0% booster notes with barrier due May 31, 2022 linked to the lesser performing of the iShares MSCI EAFE exchange-traded fund and the Euro Stoxx 50 index give investors a fair chance to outperform the market given the “booster” and uncapped upside as well as what advisers considered to be a generous barrier on the downside. While the structure is a worst-of, the high correlation between the two underliers adds another layer of safety, they said.

If the lesser-performing asset increases to more than 142.3% of the initial level, the payout will be par plus the gain of the lesser-performing asset, according to a 424B2 filing with the Securities and Exchange Commission.

If the lesser-performing asset increases but does not exceed 142.3% of the initial level, the payout will be par plus 42.3%.

If either asset falls by up to 30%, the payout will be par.

If either asset falls by more than 30%, investors will be fully exposed to the decline of the lesser-performing asset.

Two good things

“This is a pretty good note,” said Tom Balcom, founder of 1650 Wealth Management.

“One, it has a healthy downside protection if Brexit becomes more of a problem or if international markets drop as a result of trade wars.

“And two, if these markets are slightly up or even flat over three years, you get 12.5% [compounded] per year, which is very nice.”

No cap

Another attractive feature was the 100% participation rate in the appreciation above the 142.3% level.

“Often you get capped on the upside. Here you get one-to-one, which is great,” he said.

“If you’re bullish, you’re still long the index. You’re long the price index, not the total return index. But still.”

He was referring to the fact that noteholders are not entitled to receive dividend payments.

Both underliers yield about 3%, which brings the “opportunity cost” to about 9% over the period.

For Balcom, this is part of the natural trade-off associated with structured investments.

Dividends versus booster

“It’s always like that, and in this case, you’re nicely compensated for giving up dividends,” he said.

As long as the gain of the worst-performing asset is below the digital amount minus the total amount of dividends – or below about 33% - investors in the notes will beat a long position in the market, he said.

“You can still be bullish. The booster gives you a very good edge over a long position,” he said.

“What are the odds that the worst performer would be up by more than 33% in three years? It’s possible. If you’re really bullish, you should probably just buy the index. But the note doesn’t really hurt you that much even if the market is up a lot. You still get the upside minus the dividends, which isn’t bad.

“And if the index is flat, you are going to significantly outperform the market.”

Downside range for alpha

On the downside, the notes also allow investors to outperform depending on how much the worst-performing asset will drop. If it finishes between negative 9% and negative 30%, the notes generate alpha over the reference asset.

“It’s still a pretty wide range,” he said.

Overall, the size of both barrier and digital payout enable the structure to generate excess returns.

High correlation

The worst-of payout, however, is an added risk, and one that by definition eliminates the best outcome.

But it’s also how the issuer is able to provide the double-digit guaranteed minimum return, Balcom noted.

In this case, the worst-of doesn’t significantly increase the risk due to the choice of the assets, he added.

The iShares MSCI EAFE ETF tracks developed markets ex-U.S. and Canada in Europe, Australia and Asia. Nearly two-thirds of its portfolio is allocated to European stocks.

“There is a lot of overlap between those two,” he said.

The coefficient of correlation between the iShares MSCI EAFE ETF and the Euro Stoxx 50 index is 0.93.

“The fact that they’re highly correlated is a big plus,” he said.

“Sometimes you’re looking at [worst-of notes] with very different asset classes. One could go up a lot while the other falls and you’re penalized.

“Here they’re more likely to move in the same direction.

“I do like the note a lot.”

High boost

Donald McCoy, financial adviser at Planners Financial Services, shared a similar view.

“At first it’s almost like it’s too good to be true,” he said.

“You can worry about the dividends. But the guaranteed return of 42% is pretty high. And you get it even if those markets are flat.

“Who really expects the rate of return of these things to be very high? These are not very volatile indices.”

Neither one of the two underliers has posted a 30% loss on any given year over the past decade, according to Morningstar.

“If the worst one is up only 6% or 7% a year, you can take the 43%.”

Large-sized barrier

This adviser also liked the downside protection.

“The likelihood of either one of these two to be down 30% over three years is probably a low one,” he said.

“It’s not a buffer, but it’s a 30% barrier. It doesn’t concern me that much.”

McCoy concluded that the structure was attractive, especially in a range-bound market.

“You get a good downside coverage,” he said.

“If it’s flat or up a little, you get a big upside.

“If those markets explode, you’re not missing too much.

“It seems like a fair trade to me.”

BMO Capital Markets Corp. is the agent.

The notes will price on May 30.

The Cusip number is 06367WKT9.

© 2015 Prospect News.
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