Bank of Montreal's digital noted linked to Gold Miners ETF offer 15% buffer, low credit risk

By Emma Trincal

New York, Feb. 1 - The lower credit risk associated with Bank of Montreal's 0% buffered bullish digital return notes due Feb. 27, 2015 linked to the Market Vectors Gold Miners ETF helped offset the market risk associated with the volatile underlying fund, said Suzi Hampson, structured products analyst at Future Value Consultants.

While the risk versus return was average, pricing made the difference, elevating the product above its peers overall, she added.

If the index return is positive or flat, the payout at maturity will be par plus a digital return of 16% to 19%. The exact percentage will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 15% and will lose 1% for each 1% decline beyond 15%.

Digital benefits

"We call these products digital products. You get a fixed payment if the underlying is above the initial level, which is pretty standard," she said.

"The digital option is not affected much by the volatility. But the downside risk is. You generate the downside protection by selling a put."

The Market Vectors Gold Miners ETF, which tracks mining companies' stocks, has a volatility of 26%, compared with 16% for the S&P 500 index.

"That's a huge gap," she said.

"Because it's much more volatile, more revenue will come from that put sale. It gives you more money available for the digital. From there, the issuer presumably plays around with different numbers. It's a combination of things. They have decided on the buffer level already, and they know what money they can spend on the option. It dictates how much the digital payout is going to be. Because of the nature of this payoff, the actual movement of the index doesn't affect the payoff."

One of the advantages of the structure, she noted, was its simplicity.

"It's quite easy to explain," she said.

"We're seeing many autocallables, and these digital [products] share some similarities with them.

"But in terms of explaining the payoff to the investor and what you actually get, it's much more straightforward. If it's above the initial price, you get the digital. If it's below the initial price but above the buffer level, you get par. And below the buffer, you lose one for one from that level.

"I can see how easy this product may be if you want to introduce structured products to somebody."

Another benefit of the structure is that the product can outperform the fund in a flat market.

"Those products perform well in a low-volatility, low-growth environment," she said.

"You get a fixed return. It's the same as an autocallable. Those fixed and contingent returns are the theme of the moment. Rather than getting upside participation, more and more investors are trying to target a fixed return.

"Some people use it as fixed-income substitutes, although you should always remember that these are capital-at-risk products."

Credit risk

The riskmap is a Future Value Consultants indicator that measures the risk associated with a product. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

"You still have the market risk, but the buffer protects you going on the way down. If it's down 30%, you lose 15%. The notes offer an attractive alternative to the fund for a more conservative investor. It reduces your risk a lot, first for the first 15% and then it still reduces it on the way down. To pay for that, you have to accept the cap."

In its model, Future Value Consultants used a hypothetical cap of 18.25%, which is 25% below the upper end of the 16% to 19% range.

The riskmap of the product is "much lower" than the average digital, she said, citing a 2.91 riskmap for the notes versus 3.69 for the average.

The reduced riskmap of the product when compared to the average was more the result of the credit risk than the market risk, she noted.

At 2.69, the market riskmap was slightly more than 2.66, which is the average for the group.

"Bank of Montreal has a pretty good credit. And credit is what pushes down the risk in this case," she said.

At 0.22, the credit riskmap for this product is significantly less than 1.03, the average for that product type, she said.

"The five-years CDS spreads for Bank of Montreal are 35 basis points. That's much tighter than Morgan Stanley, at 142 basis points, or Goldman Sachs, at 135. Even JPMorgan's CDS of 83 basis points is wider," she said.

"If you were to look at the riskmap score and compare it to the average, it looks a lot less risky proposition. But market-wise, it is not. It really is the credit that has the big effect," she said.

Average return

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

At 7.14, the return score is "just about" average, she noted. The same product type shows a 7.19 average return score.

"While the gap between this product and its peers is substantial when it comes to risk, it is not the case with the return score. Return here is simply average. That's because the riskmap is more affected by credit. The credit doesn't impact the return score as much, but the market risk does," she said.

The attractive buffer was introduced to reduce the impact of volatility, she said.

"You don't see 15% buffers that often. For that duration and on a typical S&P 500-based product, it's usually more like 10% or even 5% and in many cases nothing at all. This one is close to the upper limit," she said.

"But you're dealing with a more volatile underlying. To reduce the risk, the issuer introduced some more protection with the buffer.

"If you had wanted to recreate the same product, the same terms, the same 9% annual return but on the S&P, chances are you would have had a 5% buffer instead of 15%. But here, given the extra volatility, the issuer is in a position to offer a generous return and the downside protection."

Price, overall

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

At 8.27, the price score is much higher than the 6.83 average price score for the same product type.

"It's a very good price score," she said.

"It could be that you have the 16%-19% range. Since we use a hypothetical cap on the upper end, it may have an impact. But even then, it does seem to be a good value product. It certainly was tightly priced," she said.

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

"The price score is higher than average. The risk is comparable to the average; you're not taking on more risk. The credit risk is very good. And the return score is average," she said.

"This gives you a 7.71 overall score, which exceeds the average digital product."

The average overall score for the same product type is 7.01.

"The return score tells you that you're in line with the rest of the market. You have a very good price score.

"As long as you're getting a fair return and that it's fairly priced, that's what you're looking for.

"It's in the right quarter of the chart, on the top left corner, compared to the rest of the market." She referred to a Future Value Consultants chart showing riskmaps against overall scores.

"Once you choose a product type and an underlying, you want to find products that belong to that category in that portion of the chart," she said.

The notes (Cusip: 06366RLK9) are expected to price Feb. 25 and settle Feb. 28.

BMO Capital Markets Corp. is the agent.

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