BMO’s autocallable worst-of tied to S&P 500, iShares EM show risk, complexity, advisers say

By Emma Trincal

New York, April 28 – Bank of Montreal’s 9.6% autocallable cash-settled notes with conditional interest payments due May 31, 2017 linked to the lesser performing of the S&P 500 index and the iShares MSCI Emerging Markets exchange-traded fund present a disappointing risk-reward profile, and the complexity of the product can be challenging, advisers said.

The contingent interest rate will be payable monthly if each underlying asset closes above its coupon barrier, 75% of its initial level, on the observation date for that month, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par plus the coupon if each underlying asset finishes above the 110% call level on any call date beginning Dec. 27, 2016.

The payout at maturity will be par plus the coupon due unless either component finishes below its initial level and either of the components dropped below the 75% trigger level during the life of the notes, in which case investors will be fully exposed to any losses of the worse performing component.

Equity type

“This is a worst-of autocall. We do a lot of these as fixed-income substitutes,” said Steve Doucette, financial adviser at Proctor Financial.

However, this product was in many ways very different from those he routinely buys for his clients.

“I see this one as an equity replacement, not as a fixed-income substitute. The terms make it very easy to lose principal. You have full downside exposure with limited upside.”

Low correlation

One factor of risk was the use of two non-correlated assets. Moreover, one of them, the iShares MSCI Emerging Markets ETF, showed more volatility than the S&P 500 index.

“It’s not as if you bought the S&P and the Russell. The EEM is a very volatile fund. It can easily breach within a one-year period.”

He used the symbol “EEM” under which the iShares MSCI Emerging Markets ETF is listed on the NYSE Arca.

American barrier

In a worst-of, the two or more underlying assets need to close above the barrier in order to maintain the protection. But in this case, the applicable observation date is not the maturity date but “any trading day.” This type of barrier known as “American,” in reference to the option used to design it, brings much more risk, he noted.

“You have the worst-of plus the American barrier. I look at my risk-return and I’m not convinced that it’s worth the risk. If you breach this barrier at any time, you’re exposing yourself to be in the worst possible scenario, long the worst index on the downside with a limited upside potential.”

Timing

Finally the one-year tenor was also a risk factor.

“The uncertainty of this note is just timing. We know a bear is coming. It’s just a question of when,” he said.

“In six months, you could take all this all the way down and you can’t get back.

“I might look at a longer duration, which gives you more favorable terms.

Doucette said the notes would also be hard to explain to a client.

“There is a lot of moving parts and too many possibilities on the downside,” he said.

Given all the risk, a participation note may have been a better alternative, he said.

“The emerging markets have been underperforming. If there is a rebound you may miss on the upside.”

Alternatives

Doucette explained that his hesitations about the deal were not due to the structure employed but to the specific terms of the product.

“We’re used to those products. We’ve done worst-of autocall with contingent coupons. But most of the barriers we look at are in the 30% to 40% range. We think in most cases the bear market is covered,” he said.

“And the barriers we used are only at maturity. We don’t use American barriers.”

The notes would make sense for investors having a very definite view, he noted.

“You have to be pretty confident that none of those two assets will go down by more than 25%. You also have to be pretty confident that they won’t go up by more than 9.6%,” he said.

“The 9.6% looks good. But there’s a huge amount of risk in this note.”

Complexity

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said that he has seen much better income plays before.

For one, the terms were hard to understand.

“I would like to have the issuer explain this to an investor,” he said.

“It sounds like a very complicated timepiece. If all mechanisms work well together, you benefit. But if one tiny component goes awry, then none of the mechanisms work well together.”

He was referring in particular to the worst-of payout: investors benefit when both underliers meet a barrier condition. But the breach of the barrier by only one of them is enough to trigger a negative outcome.

Rich valuation

The choice of the underlying assets was not helpful, he added, nor was the barrier type.

“When you do a daily observation and you use two separate indices, one which is highly valued, and the other, very volatile, trying to get to a point where you understand your expectations is challenging.”

The high coupon was not enough in his view.

“A 9% coupon on the surface is interesting. But the complications to the note make it pretty undesirable,” he added.

Tenor

Finally Medeiros said that the short tenor added even more risk.

“You buy the S&P at a pretty high valuation and the emerging markets can go either way.”

The Emerging Markets ETF has been in bear market over the past year, down 21%, but it has recently been back in favor. The fund so far this year has gained more than 7% versus 2.5% for the U.S. benchmark.

“Nine point six percent is a great offer. It kind of reminds me of index annuities. It’s great at first. But if you get the details, it’s far less attractive.

“I’ve seen similar notes, which try to accomplish the same thing – that is, to give you a decent coupon... and they were a lot less complicated.”

BMO Capital Markets Corp. is the agent.

The notes (Cusip: 06367TEA4) will price on May 26 and settle on May 31.

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