BMO’s series of fixed-interest autocallables tied to ETFs raise the call threshold

By Emma Trincal

New York, May 18 – Bank of Montreal announced the pricing of four autocallable fixed-rate notes with a particularity: the call hurdle is 10% above the initial price. While unusual – call triggers are typically set at initial price – sources said the feature may help collect the coupon over a longer period of time.

The four 0% autocallable cash-settled notes with fixed interest payments due May 31, 2018 have a common structure, according to an FWP filing with the Securities and Exchange Commission, which describe them all.

The interest is payable monthly.

The notes will be called at par plus the coupon if the fund closes above its 110% call level on any monthly call date.

The payout at maturity will be par plus the coupon due unless the fund finishes below its trigger level, in which case investors will lose 1% for each 1% decline.

Coupons and barrier levels are a function of the underlying fund.

Four ETFs

One deal is linked to the VanEck Vectors Gold Miners exchange-traded fund. It offers the highest coupon at 10.8% a year. The barrier is the widest at 70% of the initial price. The underlying is also among the most volatile of the four with an implied volatility of 32%.

The second offering is based on the SPDR S&P Oil & Gas Exploration & Production ETF. It offers a 10.2% fixed-rate and a 75% barrier. The implied volatility is at 33%.

Another upcoming offering is based on the SPDR S&P Bank ETF with a 6.9% coupon and a barrier level of 80%.

Finally the fourth one is linked to the iShares Nasdaq Biotechnology ETF with a 6.6% coupon. The barrier is also at 80%.

The last two deals, which offer the lowest coupon, also showed lower volatility levels at 23% and 20% respectively.

Higher strike

“I like the idea of the higher threshold. I haven’t seen that before,” said Steve Doucette, financial adviser at Proctor Financial.

He was referring to the 10% hurdle above the initial price, making the call less likely than at par all things being equal.

“You may not be called right away and so you may be able to collect your coupon longer,” he said.

The volatility of each underlying fund however may offset this outcome, he added.

As with any reverse convertible, the upside is capped at the coupon level.

If the price hits 10%, investors get 100% of their principal back plus the coupon, not necessarily 110%, he noted.

In fact, investors get less than the price appreciation of 10% in two of the deals, in which the coupon is 6.9% and 6.6%.

Premium

Not getting the full upside is part of the embedded option strategy known as call writing, explained an option trader.

The coupon is obtained by selling a call at the strike price of 110.

“It’s not unusual to get less,” he said.

“If you sell 110 on a stock, they’ll give you 6% or 7% even if there’s a 10% increase. Nobody will pay you 10.”

The call writer is betting that the stock will rise up to the strike price. He gets paid a premium for the risk of having to give up the upside above 10% or being called.

The option trader said that the strategy also included some downside protection.

“You’re looking at a collar,” he said.

“You have your 6% premium and your 20% downside protection.”

A collar is an option strategy in which an investor writes a call and buys a put option with the same expiration. The put protects a long position in the stock while the short call provides some income through the premium.

Fixed-income, not equity

Doucette said that one of the errors investors sometimes make is to get confused between two separate goals: getting equity returns and getting some income.

When investors buy a note for yield, they should accept the notion of capping their upside.

“You shouldn’t be concerned about getting called a 110% and getting less than 10% in return. This is a fixed, guaranteed coupon and you also have the barrier,” said Doucette.

“This is why even with the equity risk I always look at those autocalls as fixed-income substitutes.

“You buy this kind of note for the yield, not for the upside.”

Principal at risk

However market risk had to be considered.

“Do I want to take a fixed-income substitute and lose some of my principal? If you go down 80% your loss is more than the fixed-income. Are you willing to take that risk simply to reach for a higher yield?” he said.

The answer to that question would depend on the underlying. Out of the four ETFs, Doucette said that the gold miners would be the one he would focus on.

“It’s the only one that stands out because gold is not as much correlated to the market as the other ones.

“I would have to go back and do my due diligence on gold, see how it held out in the last bear market.”

The 10.8% coupon was part of the appeal.

“Would I want to take the full downside risk of biotech stocks for a 6.6% coupon? Probably not,” he said.

Too volatile

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said volatility was a concern.

“With these particular underliers I wouldn’t be a fan,” he said.

“I think there is a pretty good likelihood that they will get called anyway because some of these indices are big movers.

“If I was bullish on one of these, I’d much rather be long the index with a buffer.”

The gold miners fund was particularly volatile, he noted.

“This one moves two-to-one. When gold is down two, the miners drop four,” he said.

Long the upside

Medeiros would find it a better strategy to have a one-to-one exposure on a less volatile underlier.

“I would prefer looking at the S&P. I have a return expectation of 8%. The notes are callable at 10%. But I get a coupon of 6.9%. That would make sense.

“I’m not quite seeing the opportunity in these.”

BMO Capital Markets Corp. is the agent.

The notes will price on May 25 and settle on May 31.

The Cusip numbers are 06367TWE6 for the gold miners; 06367TWD8 for the oil fund; 06367TWT3 for the banks ETF and 06367TWF3 for the biotech fund.

© 2015 Prospect News.
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