Advisers compare two BMO S&P-linked notes designed for different profiles, strategies

By Emma Trincal

New York, Aug. 25 – Bank of Montreal priced two seemingly similar, yet very distinct deals created for two different types of investors, leading advisers to debate about which of the two would be the best option and for whom.

The deals shared some common characteristics: both notes are linked to the performance of the S&P 500 index and mature on Aug. 24, 2027, according to 424B2 filings with the Securities and Exchange Commission.

But the differences are notable. The first deal offers full downside protection. The payout is the index gain capped at 62.9%. The second offering on the other hand comes with a 70% barrier on the downside and offers uncapped leveraged return on the upside.

It’s time

Matt Medeiros, president and chief executive of the Institute for Wealth Management, without hesitation said he liked the leveraged note best.

“My preference is for the second. And the reason is time,” he said.

“The notes are pricing when the S&P is down 12% for the year. That gives me a decent entry point. But more importantly, five years allows me to go through a full investment cycle.

“Therefore, I’m reasonably confident that I won’t hit the barrier at maturity.”

Booster needed

He stated another reason for his preference for the second deal.

“I like the leverage without having a cap on the upside. Currently, my return expectations are conservative for the S&P. So having the return enhancement without the cap is attractive,” he said.

“If I compare this with the first one, the decisive factor to me is time.

“On a five-year, the 100% principal-protection is nice, but it’s not going to mean a whole bunch to me.

“The cap is OK, but not having any leverage is not helpful when your return expectations are moderate.”

Low fees

A financial adviser said he understood that the principal-protected note may have some appeal for a certain category of investors. But his personal preference also went to the second deal.

He first pointed to the similarities between the two products.

“Same issuer, same timeline, same underlying,” he said.

“The five-year doesn’t intimidate us. We stagger notes maturing at different times.”

He also liked the low fees on both deals, which are 0.6% and 0.1% for the first and the second deal, respectively.

“Those fees are ridiculously low. Just a few basis points per annum. You can’t even get an index fund for that.,” he said.

Principal-protected

This adviser first looked at the principal-protected note.

“This one is for somebody who doesn’t want to take any downside, someone who doesn’t want to lose any money,” he said.

A typical client would be a 75-year-old retiree for instance, he said.

“But there’s a cost for the protection and you’re giving up a ton of benefits.”

The 62.9% cap is approximately the equivalent of a 10% annualized compounded return, he noted.

“That’s a great return,” he said. “That’s what many investors are shooting for. But what are the odds of underperforming the market?”

The frequency at which the S&P 500 index has returned more than 62.9% over five-year rolling periods is 37.3%, he said, based on statistics he has compiled on the S&P 500 index going back to 1950.

The chances for the index to be positive but below the cap level are 45.9%, he added. In this scenario, investors will market perform.

“You only outperform on the downside, which is about 17% of the time,” he said based on his data.

One of the risks was to be “capped out” if the index was to finish higher than 62.9%, which happens more than a third of the time, he said. At the same time, a 10% compounded was “nothing to sneeze at,” he said.

“This note is really for people who want zero downside risk and are willing to give up some of the upside so they can sleep at night,” he said.

In either scenario, investors will still “lose” the 1.45% dividend yield associated with the S&P 500 index over the five-year period.

Levered, uncapped

“The second note is a far better deal,” this adviser said.

“With the 34% leverage and the uncapped upside, you will outperform the market even taking the loss of dividends into consideration. Anything positive, you’ll beat the market unless the S&P is barely up.”

Adding the two probabilities associated with the two upside scenarios – 37.3% over the cap and 45.9% below it – investors will outperform the benchmark over 83% of the time, he noted.

“The upside potential is huge. It’s not principal-protected. But you still have a 70% barrier.”

This adviser said he would be “concerned” about a 70% barrier on a two-year note, but not on a five-year.

“The chances of finishing down more than 30% after five years are statistically negligeable,” he said.

A matter of taste

This led him to conclude that the full principal-protection was probably unnecessary over the period.

“Your chances of losing money over five years are extremely small. It’s a stretch but I would say that using full downside protection on a five-year note is like putting municipal bonds in an IRA. Again, it’s a matter of individual choice. You can’t fight a client whose main goal is to be able to sleep at night.

“Some people buy annuities and lock themselves for several years because it’s guaranteed even though it’s a lousy investment.

“For clients who love CDs and get spooked about the market but still want exposure to it, the first deal is probably a better option. For everyone else, the second one is much, much better,” he said.

Bank of Montreal’s $1.05 million of 0% market-linked notes (Cusip: 06374V2Z8), which offer the principal-protection, and Bank of Montreal’s $2.1 million of 0% barrier enhanced return notes (Cusip: 06374V2W5) priced on Aug. 19 and settled on Wednesday.

BMO Capital Markets Corp. was the agent for both.

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