American barrier in BMO’s $1.96 million autocalls on ETF, indexes seen as a drawback

By Emma Trincal

New York, April 8 – Bank of Montreal plans to price autocallable barrier notes with contingent coupons due July 11, 2022 linked to the least performing of the S&P 500 index, the Russell 2000 index, and the VanEck Vectors Gold Miners exchange-traded fund, according to an FWP filing with the Securities and Exchange Commission.

Interest is payable monthly at an annual rate of 11% if each asset closes at or above its 65% coupon barrier level on the applicable monthly observation date.

The notes will be called at par if each asset closes above its initial level on any monthly observation date beginning Oct. 7.

The payout at maturity will be par unless any asset finishes below its 60% trigger level at any point during the life of the notes, in which case investors be fully exposed to any losses of the least performing asset unless all underliers close above their initial levels in which case the payout will also be par.

Any day barrier

Steve Doucette, financial adviser at Proctor Financial, said he liked almost everything about the structure.

“You get 11%. That’s a very nice coupon. They put a pretty good barrier on it: 60% at maturity. The only thing is this daily chance to burst the barrier. That’s the problem. I don’t really like those American barriers,” he said.

American barriers are observed on any trading day during the life of the notes, which is the type of barrier employed in this structure for the barrier at maturity. This type of daily observation is less common with structured notes, which typically use point-to-point observations, so-called European barriers. Only the coupon barrier is European with this note.

What-if scenario

Rather than focusing on the negative, Doucette analyzed the notes on a hypothetical basis as if the barrier at maturity was European instead of American.

“The markets may go down 40% in 15 months. Or they may not. Anything can happen. It would have to happen quickly. It’s not likely,” he said.

“The greater risk is the GDX. It has more volatility than the two broader benchmarks.”

The VanEck Vectors Gold Miners ETF is listed on the NYSE Arca under the “GDX” ticker.

“Everything in this note depends on what happens to gold. In a way, the price of Bitcoin is a factor too because depending on what Bitcoin does, gold could jump or plunge.”

“A lot of people are predicting that Fiat currencies are going to be digitalized. If Bitcoin falls, people may buy gold as an alternative. If it rallies, they may dump gold. You just don’t know.

“I guess the only risk I can see here is something competing with gold.”

Negotiating the barrier

Correlations between the two equity market indexes and the gold miners ETF was also a factor. The lower the correlation, the greater the risk is. While the S&P 500 index and the Russell 2000 index have a coefficient of correlation of 0.82 (1 being perfect), the ETF and the S&P 500 index have a correlation of only 0.14 while the Russell is slightly negatively correlated with the gold miners fund.

“Many things can affect the market. It could be Bitcoin. It could be the Nasdaq. The markets aren’t rational. They are reactive,” he said.

But given the depth of the 60% barrier, Doucette said he was confident that the volatility risk associated with the price of the precious metal could be contained, at least based on his barrier assumption.

“They picked the gold ETF to add some of the return. And I don’t feel it adds that much risk,” he said.

“If it was a normal barrier at maturity, I would be comfortable with the barrier and the risk-return.”

But the daily monitoring of the barrier added a level of risk Doucette said he was not willing to take.

“I never liked these American barriers. Knowing how volatile the market is, it’s just adding too much risk,” he said.

“I would be willing to give up some of the coupon just to eliminate that risk. I could go down 1% or 2% if I had to.

“If it didn’t work, I might look for different underliers...see what the options are.”

Risk management

Matt Medeiros, president and chief executive officer at the Institute for Wealth Management, also ruled out this type of barrier, saying the daily observation was a drawback.

“I don’t mind the GDX. However, I am concerned about the volatility of this ETF. Big moves can easily knock out this barrier since it can happen anytime during the entire holding period. It’s a lot riskier than a single observation at the end.”

But the main challenge was to efficiently monitor such risk.

“I wouldn’t want to purchase a note not knowing in advance if I’m going to have a protection or not. That’s the problem,” he said.

“If this was a point-to-point barrier, I would be fine with the same underliers. But it’s not.”

Upside, call risks

Medeiros had another “concern,” related to the upside.

“If you get called in six months, and that’s totally possible, you’re only getting 5.5% in return.

“You could do better with the major indices directly, for sure. The market can move 2% in a day.

“So, I think the cap is an issue here.”

Medeiros said he is bullish on the U.S. equity market now.

He pointed to the impact of the government stimulus, the economic improvement as vaccinations progress and the Federal Reserve Board’s accommodative policy.

“I do have concerns about inflation, but I don’t see inflation as an immediate threat. It will play out in a year-and-a-half to two years, probably not in the next 15 months.”

Given his bullish outlook, Medeiros would not use the note in the equity bucket of his portfolio seeing it as a bond replacement instead.

“It would be an income play. I wouldn’t buy it for the appreciation.

“It has more risk than a fixed-income investment. But that’s how you enhance the coupon.”

BMO Capital Markets Corp. is the agent.

The notes priced on Tuesday and will settle on Friday.

The Cusip number is 06368EJ86.

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