Bank of Montreal's 13.25% reverse exchangeables tied to Netflix target aggressive investors

By Emma Trincal

New York, July 22 - Bank of Montreal's reverse exchangeable notes due Jan. 31, 2012 linked to the common stock of Netflix Inc. are for "fairly aggressive investors" given the underlying stock's high implied volatility, said Gurdeep Ubhi, structured products analyst at Future Value Consultants.

The six-month notes carry a coupon of 13.25% per year, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable monthly.

The payout at maturity will be par unless Netflix stock closes below the trigger price - 80% of the initial share price - during the life of the notes and the final share price is less than the initial share price, in which case the payout will be a number of shares of Netflix stock equal to $1,000 divided by the initial share price or, at the issuer's option, a cash amount equal to the value of those shares.

The stock is up 57% for the year.

Its implied volatility is 48%.

Do no harm

"The job of a reverse convertible is not to hit the barrier," said Ubhi. "In an ideal scenario, your stock stays flat and you collect your coupon without losing any principal."

But given the volatility of the stock, the risk of breaching the 80% barrier is greater, he noted.

In addition, a six-month term, which is short compared to the average structured product, contributes to add risk, he said.

"If the stock price breaches the barrier at some point, which is possible, the chances of recovery are not great," he said. "If you're down 20%, you can always go back up, but it's not very likely."

High riskmap

The risk associated with the investment is reflected in riskmap, one of Future Value Consultants' ratings.

The higher the riskmap, the higher the risk of the product is on a scale of zero to 10.

The riskmap compares the average product underperformance (relative to cash) with the average underperformance of five sample assets of different volatility levels. The risk rating equates the risk of the products against the five hypothetical assets.

The Bank of Montreal notes received a 6.82 riskmap, which is higher than the average similar structure (6.31) and even greater than the average of all products recently rated (5.49).

The riskmap is decomposed into a market riskmap and a credit riskmap.

The market risk follows the same zero to 10 scale as well as calculation rules of the overall riskmap but with issuer credit risk ignored.

Market risk essentially

For these notes, all the risk is borne by the market risk, which at 6.55 and is higher than that of other products.

"Here the credit risk is below average but the market risk is high because of the volatility," he said.

Ubhi said that the six-month reverse convertibles last month showed an average barrier of 77%, which could explain why the risk is greater for this product than for its counterparts.

In the bank's term sheet, he noted, a total of 13 reverse convertibles with a six month term were announced and their average barrier was 78%, which is less than 80%.

"As the volatility of Netflix is fairly high, you may have to be quite aggressive and optimistic, trusting that the 20% barrier will do its job," he said.

The market risk is also elevated compared to the 5.07 score for all products. One factor is the fact that many growth products offer a buffer rather than a barrier.

Another reason, said Ubhi, is because the barrier used in this product is an American-style option, which means that the barrier can be breached at any time during the life of the notes, versus a European barrier, in which the downside threshold can only be triggered once, at maturity.

"It's definitely more risky when your barrier can be knocked out anytime," he said.

Risk-adjusted return

The return score for this product is below average, at 4.97 compared to all products (5.99) and to the group of notes with a similar structure (5.45).

A low return score means that the return compared to the risk is low.

The return score is Future Value Consultants' opinion of the risk-adjusted return under reasonable and consistent forward-looking assumptions for underlying asset evolution on a scale of zero to 10.

Compared to all other products, the low return score can be explained by the payout, he said.

"With a reverse convertible your return is limited to the coupon, which is a cap, while an investment in an accelerated growth or uncapped note offers more potential upside," he said.

"In addition, a lot of the growth products are linked to a less volatile asset than a stock, such as an index or a fund. It limits the odds of losing some of your capital."

Compared to other reverse convertibles, this product may have a lower return score due to the coupon amount.

"Many reverse convertibles are shorter. They can have a three-month maturity. With those, you typically get a higher coupon to offset the risk," he said.

The return score derives from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

The performance is modeled based on a series of parameters, which include for instance among others, volatility, dividends and interest rates.

With these notes, investors have a 61% chance of losing between 10% and 15% of their principal.

"This reflects the situation in which you get your coupon without any loss of principal, which is the best case scenario," he said.

On the other hand, a loss with this product is likely to be significant in size, with a 31% probability of losing more than 15% of principal.

"It's such a short-term product that once you hit the barrier, it's likely that you won't recover," he said.

Price score

The notes also show some weakness in terms of pricing as illustrated by a price score of 3.87.

Based on a scale of zero to 10, this score represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis and profit margins on the underlying derivative.

The score is higher than other reverse convertibles but much lower than the average product.

"The score reflects our view that the issuer could have offered a higher coupon or a lower barrier given the risk investors are taking due to the high volatility of the underlying stock," he said.

Future Value Consultants through its overall score delivers its opinion on the quality of a deal, by averaging the price score and the return score.

The notes received a 4.42 overall score. It is slightly less than the average product with a similar structure (4.56) and significantly less than all other products (5.66).

"Both the return score and the price score have certainly brought down the overall rating," he said.

The notes (Cusip: 06366QSG3) are expected to settle Friday.

BMO Capital Markets Corp. is the agent.

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