BMO’s autocallable notes on S&P, Russell offer unusual features to work in sideways market

By Emma Trincal

New York, Jan. 7 – Bank of Montreal’s autocallable cash-settled notes with fixed interest payments due April 13, 2021 linked to the lesser performing of the S&P 500 index and the Russell 2000 index show an unusual combination of at least three features in an income-generating autocallable worst-of deal, according to a 424B2 filing with the Securities and Exchange Commission.

One is a 6.84% per year guaranteed coupon payable monthly.

Another one is an automatic call trigger set at 105% rather than at initial level. The call is quarterly and kicks off after six months.

Finally, the issuer set an “American” barrier for the principal repayment at maturity. It means the downside protection may be knocked out on any trading day. If either index finishes below its initial level and either index ever closes below its 70% trigger level during the life of the notes, investors will be fully exposed to any losses of the lesser-performing index.

Solid barrier

The American barrier allowed for the payment of a fixed rate, noted Tom Balcom, founder of 1650 Wealth Management. This riskier option also enabled the issuer to include what he considered to be a sizable amount of contingent protection especially over a 15-month term.

“70% is pretty healthy even though it’s an American barrier,” he said.

“I’m expecting some volatility this year. But we shouldn’t have a 30% drawdown. Unemployment is very low; the economy is strong. I don’t anticipate a big pullback.”

Risk-reward

The interest rate offered an attractive premium over the one-year Treasury, which yields 1.5%.

“You get more than four times the risk-free rate, so obviously you have to take some risk,” he said.

One risk factor is the 105% call threshold, which may appeal to investors seeking to collect the coupon as long as possible. While it reduces reinvestment risk, it also increases exposure to market losses.

“But in my opinion, this risk, including the American barrier, is mitigated by the size of the protection. A 30% drop is pretty big. The probabilities of losing your protection even any day isn’t that big. I like the protection,” he said.

Not like a bond

Donald McCoy, financial adviser at Planners Financial Services, was not so sure the barrier offered a solid level of downside protection although it did when compared to an outright position in the indexes.

He first pointed to the complexity of the structure.

“Having to explain the concept of the American barrier in addition to the worst-of as well and all the contingencies can make it a little bit difficult for an adviser and a client,” he said.

The note had its place in some clients’ portfolios or for a particular allocation but its use remained limited.

“I would not buy it for a fixed-income portfolio or offer it to a conservative investor because there is a lot of downside risk,” he said.

“It would not be suitable.

“The 6.84% coupon is great, but there are other ways to get income that are far less risky.

“You have to keep in mind that your maximum return is 6.84% a year while you’re 100% exposed to the downside.”

Range bound view

Given the risk, the notes could be used as an equity replacement despite the relatively low return, he said.

But here again, it would not be suitable for all investors. For instance, the note would not be a good addition to a bullish portfolio.

Investors eligible for this investment would have to have a “very specific” view of the market.

“You’re betting that the index is going to be flat or up but not by much. You don’t rule out the possibility of a market going down but you don’t see it falling off a cliff. You just don’t have a lot of faith in equities and so you want to squeeze something out of it to at least get something.”

Generating income, alpha

This strategy could possibly outperform a long position in a down market.

“At least you have some protection while there is downside risk if you’re long the market.”

He gave an example, in which the barrier never breached during the life but both indexes finished negative.

Investors in the notes would have earned 8.55% over the 15-month period while an equity investor with similar exposures would have incurred losses.

“You’re putting some of the equity risk off the table to generate some income,” he said.

“But it’s not a pure income play because it’s designed for aggressive investors.

If you’re saying: the market is prone to a downturn. Let’s just give ourselves at least some downside protection with the ability to generate some income, then it makes sense.

BMO Capital Markets Corp. is the agent.

The notes will price on Wednesday.

The Cusip number is 06367WTS2.

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