BMO Harris’ callable stepped digital CDs linked to Russell 2000 may not hedge inflation well

By Emma Trincal

New York, Nov. 16 – BMO Harris Bank NA’s callable stepped contingent monthly digital payout certificates of deposit due Nov. 28, 2036 linked to the Russell 2000 index offer step-up rates above current CD rates, but several risks made advisers skeptical about the structure.

Interest is payable monthly if the index closes at or above the threshold level on the coupon determination date for that month, according to a term sheet.

The contingent coupon rate will be 3% per year in years one through 10, 4% per year in years 11 through 15 and 5% per year in years 16 through 20. The threshold level is expected to be 72% to 78% of the initial index level and will be set at pricing.

The payout at maturity will be par plus the final coupon, if any.

Beginning Nov. 30, 2017, the CDs will be callable at par on any coupon payment date.

Greenspan bet

“You’re locking rates for 20 years when rates are historically low, and you’re not even guaranteed the payment since it’s based on the Russell 2000 performance. I happen to be bearish on this index,” said Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments.

The first problem is the risk of inflation ahead.

He noted that investors have no chance of getting more than 5% for the entire term and such rate would only be available at the end. For the first 10 years, their return would be limited to 3%.

“At some point, inflation is going to pick up a lot. Today we have low rates. People may think 3% looks good. But that’s now. Once rates start to move up, you’ll be stuck with a lower rate for a long time.

“Greenspan himself is predicting 5% rates.”

In a recent interview with Bloomberg, former Federal Reserve chairman Alan Greenspan said that “we could shift away from excessively low interest rates fairly soon,” citing a move to 4% or 5%, adding that “we’re moving into the very early stages of inflation acceleration.”

Zero-coupon risk

Kaplan’s second issue with the product is the contingency of the coupon.

“Your return is linked to the performance of the Russell 2000. That could leave you without income for a few years,” he said.

The CD wrapper protects investors against market declines. The Federal Deposit Insurance Corp. provides limited credit risk protection up to $250,000, according to the term sheet.

But Kaplan stressed that the real risk for investors is associated with the contingency of the coupon.

“The Russell could easily drop 30%. If that happens, you’re not going to get your interest.”

Depending on how long a bear market may last, investors could incur a significant erosion of their return, he said.

Valuation, call

Tom Balcom, founder of 1650 Wealth Management, mentioned two other risks.

“Obviously, you have higher rates than regular CD rates. But the problem is the duration,” he said.

“As interest rates go up, the value of your principal will go down.

“How do you explain that to investors? I don’t believe in saying, oh, don’t worry! You hold this investment to maturity.

“We have to explain that to the client every time they get their statement.”

In contrast, if rates go down rather than up, reinvestment risk occurs, he said.

“They can call it after just one year. As soon as rates drop they will call you out. Then you have to reinvest at lower rates,” he said.

He concluded that a note paying contingent coupons based on equity returns with a discretionary call and a long maturity should offer a better risk-adjusted return.

“You’d want to get a juicier yield than 3%. A 4% to 5% guaranteed would make more sense.”

BMO Capital Markets Corp. is the agent. Incapital LLC is distributor.

The CDs will price Nov. 28.

The Cusip number is 05581WKQ7.

It is the first time in two years that the issuer has priced a structured CD, according to data compiled by Prospect News.

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