Bank of Montreal’s barrier digital notes tied to Russell offer bullish alternative to fund

By Emma Trincal

New York, Oct. 27 – Bank of Montreal’s 0% bullish digital return notes with barrier due Dec. 29, 2017 linked to the Russell 2000 index are likely to outperform the small-cap benchmark in a range bound market, a financial adviser said.

If the index finishes at or above the initial level, the payout at maturity will be par plus the digital return of 14.75%, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 10% and will be fully exposed to any loss if the index finishes below the 90% trigger.

High cap

“If you’re looking at historical returns for the Russell, this might be a better option than just investing in the index directly because the Russell would have to go up to around 1,377 in order to equate the cap. It’s unlikely,” this adviser said.

The Russell 2000 index, the small-cap U.S. equity benchmark, is currently trading at approximately 1,200.

“To get to the cap [or 1,377], you would have to be above the all-time high of June 2015.

The Russell hit an intraday high of 1,296 on June 23 of last year.

Unless the index breaks new records at a time when analysts expect stock prices to show modest returns, the digital payout offers investors a chance to outperform a direct investment in the Russell 2000 fund, he said.

“If we continue to have a flat or range bound market, this note makes sense over the Russell because you would get 14.75% and it would give you some protection on the downside.”

Downside

“Naturally, there is also the probability that the index would decline by more than 10% to 1,080,” he added, which would eliminate the benefit of the downside protection. Investors in this case would be long the price return of the index.

The 1,080 barrier threshold would be close to the last significant bottom of 1,090 observed earlier in June, he noted.

“There is some support level, so that’s constructive. But if we do have a broad market sell-off as people suspect we may have, then the barrier would not protect you.

“That would apply to the market in general though. You wouldn’t be at a disadvantage compared to the index in that scenario.”

Short-term outlook

This adviser said it is too soon to tell whether the U.S. market is heading for a correction.

“It’s going to depend a lot on the third-quarter earnings. We’ll know more when the season is over. If we have a sixth quarter of negative earnings, in my opinion, we’ll be in a recession,” he said.

If the S&P 500 index reports a decrease in earnings for this quarter, it will mark the first time the index has seen six consecutive quarters of year-over-year declines in earnings, according to FactSet, which began tracking this data in the third quarter of 2008.

Because of the risks of a recession or market correction, this adviser would not be investing in the notes.

But he said it had more to do with the underlying investment theme than the product itself.

“I wouldn’t invest in the Russell on an absolute basis right now. But if I was, on a relative basis, this might be an attractive play,” he said.

Upside potential

Matt Medeiros, president and chief executive at the Institute for Wealth Management, said he was concerned about the downside risk associated with the structure.

“In the case of small-caps, I’m not too fond of short-term products,” he said.

The upside potential offered by the notes was not his main concern.

“Small-caps have underperformed large-caps since the recovery of 2009 and this asset class currently has better valuation and appreciation potential compared to large-caps.

“And yet, I am not as focused on the cap as I am on the downside protection. I think the cap is reasonable.”

Limited protection

Instead, Medeiros stressed the risk of a recession in the short-term pointing to the volatility of the Russell 2000 index.

“Ten percent barrier, I think is not that appealing. We could potentially be facing some global economic challenges soon,” he said.

“There are a lot of variables that could push the market into negative territory, and if that happens, then the asset class is generally more vulnerable than large-caps. So I’m not sure it’s the right timing to do that, at least not with that amount or type of protection.”

BMO Capital Markets Corp. is the agent.

The notes will price on Nov. 28 and settle on Nov. 30.

The Cusip number is 06367TNA4.

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