Bank of Montreal's buffered notes linked to metals basket offer defensive play in metals

By Emma Trincal

New York, Jan. 10 - Bank of Montreal's 0% buffered notes due Jan. 29, 2016 linked to a basket of metals target skittish commodities investors seeking some downside protection at the cost of a possibly decreased return on the view that the metals rally may be bound for a correction, sources said.

The notes may be appropriate for conservative or institutional investors who want to reduce the volatility of their metals holdings while still participating in a long-term rally, a commodities analyst argued.

The equally weighted basket includes copper, lead, nickel and zinc, according to a 424B5 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus any gain in the basket, up to a maximum return that is expected to be 125% to 150%. The exact cap will be set at pricing.

Investors will receive par if the basket falls by 20% or less and will be exposed to any decline beyond 20%.

"This is for someone who wants to remain positioned in metals but doesn't want to take the downside risk," said Keith Springer, financial adviser at Springer Financial Advisors.

"They're getting 20% downside protection" but are subject to the cap. "They're not getting the bang for the buck, but they still want to play it," he said.

Springer noted that the notes would only be attractive to conservative investors with a moderately bullish outlook on commodities.

"They're going to miss out on the big ride - 125% to 150% over five years is not that much in commodities. It sounds like a lot, but it's not.

Portfolio buckets

Carl Kunhardt, director of investment management and research at Quest Capital Management, said that he would not consider the notes because the investment could not fit into the portfolio as a substitute for another asset class such as bonds, equities or alternative investments.

"It would be too risky to be a fixed-income substitute," he said.

"The cap would give me pause as an alternative substitute. With alternative investments, you want to mitigate risk or enhance returns. While the notes are reducing risk with the buffer, why would I want to add all that volatility and be capped at 30% a year?

"And finally, it would not work as an equities substitute. Commodities are totally uncorrelated to stocks. It just wouldn't fit in the bucket."

Kunhardt added another reason for not considering the notes. "We don't do sector plays like these. We just don't go to that level of detail, so this instrument would be an issue for us. We prefer to participate to broad markets," he said.

Defensive move

But others said that the notes offered a good instrument to more conservative investors who predict a correction in metals but don't know exactly when it will occur.

"There is an expectation of flattening in the demand curve for commodities. We've had a big upside in industrial metals recently. An inverse reaction of equal proportion - in other words, a correction - would not be unusual," said Brad Zigler, research analyst at Hard Assets Investor.

Zigler said that China, which fueled the metals bull market, could also be at the origin of what may "cool off" the rally.

"A large part of the demand for industrial metals came out from China, which bought them for its infrastructure needs. But we've seen China taking some steps to raise banks' reserve requirements, curtail lending and, recently, the strategy moved over to raising interest rates outright," he said.

"Given the volatility of these markets, these notes may be a safer bet than an [exchange-traded fund]. It makes sense for an institutional investor or a fiduciary account, depending on the creditworthiness of the issuer."

Zigler said that Bank of Montreal's A+ rating from Standard & Poor's made the notes more attractive from a risk standpoint.

"It's not a bad credit, and Canadian banks are considered better credits than their American counterparts," he said.

Diversified basket

The basket itself provided diversification, which is another risk-reducing factor compared to notes linked to the price of a single commodity, Zigler added.

For investors who sought to invest in the four metals that compose the basket, the notes offered easiness of access, Zigler noted.

"If you want access to those four metals, you can't really do that with a single ETF" or ETN, he said.

He cited Barclays Bank plc's iPath Dow Jones - UBS Industrial Metals Subindex Total Return exchange-traded note, which is weighted 45% to copper, 28% to aluminum, 14% to nickel and 13% to zinc but has no weighting in lead.

Separately, the iPath Dow Jones - UBS Lead Subindex Total Return ETN is entirely dedicated to lead without any exposure to the three other metals.

"You don't have much choice in the ETF market. As far as this basket is concerned, there is nothing that offers the same exact combination," he said.

The notes (Cusip: 06366QBH9) will price on Jan. 26 and settle on Jan. 31.

BMO Capital Markets Corp. is the agent.

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