BMO’s $1.9 million digital buffer notes on EM ETF may outperform, but volatility is a concern

By Emma Trincal

New York, June 27 – Bank of Montreal’s $1.9 million of 0% digital return buffer notes due June 26, 2026 linked to the iShares MSCI Emerging Markets ETF offer a nearly double-digit fixed payment if the underlying closes at maturity within a range on the plus and minus sides making the payout suitable for moderately bullish and mildly bearish investors. However, the volatility associated with emerging markets poses a challenge, advisers said.

If the ETF’s return is greater than or equal to its 80% buffer level, the payout at maturity will be par plus 32.5%, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will lose 1% for every 1% that the ETF declines below the buffer.

Outperformance

“The problem with this asset class is volatility. Emerging markets are very volatile, which leads me to think that the 20% buffer is mild frankly. A 20% buffer on the S&P would be great. But this is not the S&P,” said Kirk Chisholm, wealth manager and principal at Innovative Advisory Group.

Investors in the notes would outperform if the ETF finished down by no more than 20% or up by less than 32.5%, which represents a band of more than 50 percentage points to achieve possible excess return. The digital payout of 32.5% represents a 9.85% compounded annualized return.

“It seems like a wide band. But with emerging markets, you could be down 70% or up 100%. Historically you can really see huge swings so it's really a tame range. Again, you’re not having S&P exposure,” he said.

Buffer

However, having a hard buffer on the downside as opposed to a barrier was a plus, he noted.

“It’s still a decent note. I don't hate it. The buffer is nice, and that may be enough if you're confident in the asset class and want to invest in it,” he said.

“If you’re not particularly bullish or bearish and if you don’t think vol. is going to jump, this is probably a good choice.

“But to me, volatility is an issue. I can see it climbing in the next few years.”

Current implied volatility for the ETF is 16%.

Value

One bullish theme when it comes to the emerging markets ETF is its low valuation.

The deal priced at an initial level of $40.08 per share, which is 29% off the all-time high of February 2021 and 5.5% below the recent 52-week high of January. The S&P 500 index in comparison is already up 14% since January.

“Emerging markets are much more undervalued than U.S. markets. But the U.S. stock market drives international markets. So yes, emerging markets do offer big value and have for a while. But it doesn't necessarily mean you’re going to do well, and it doesn’t mean either that the notes are going to outperform the ETF,” he said.

China

One of the common criticisms about the ETF is its heavy weighting toward China, a market that represents 30% of the fund’s market value.

“Emerging markets is emerging markets. I don't really consider China as an emerging market, but people do,” he said.

“Because China is overweight, it’s going to have an influence on the index, which is a problem.

“I don't think China will do great in the next three years.”

Overall, the underlying was Chisholm’s main concern.

“If you like the asset class, it’s a decent note.

“But personally, I'm not touching emerging markets. There are some opportunities there, but I’d rather wait,” he said.

Strips

Jonathan Tiemann, president of Tiemann Investment Advisors, said that investors in the notes sacrificed a lot of the potential gains.

“9.85% a year, that’s not a big return. You chop off your upside,” he said.

The notes would be for investors targeting a specific return.

“It would be for a fixed payment, not for income substitute, since there is no cash coming out of it,” he said.

He compared the payout to that of three-year Treasury Strips, which are U.S. Treasury bonds that have been stripped of their interest. The Separate Trading of Registered Interest and Principal of Securities (Strips) are zero-coupon bonds, which are bought at a deep discount.

“A three-year treasury Strips probably yields around 5% with basically no risk. The note gives you just shy of 10%.

“So, you're getting about double what you would get for a zero- coupon treasury but you're taking some risk on the downside. You’re definitely compensated for the risk, but watch that volatility!”

Short volatility

Investors in the notes are selling volatility.

The minus 20% to plus 32.5% range of outperformance appears to be wide but not with the volatility of the asset class, he said.

“And not with that long tenor. Over three years, emerging markets can move a lot in both directions,” he said.

There is more risk long-term, because emerging markets have a long history of consecutive years of bad performance, he explained.

“You get your payoff by selling volatility. But I don't see volatility decreasing. It's been pretty low and not just for emerging markets. It’s been low in general over the past several months,” he said.

Range bound view

Tiemann admitted that he was not sure who would buy the notes.

“You would have to think that the asset class is not going to do especially well, that it's sort of going to trade mid-range or have a negative outcome,” he said.

“I would be concerned about selling of a lot of the upside, especially based on a current volatility of 16%.

“There’s downside risk. But I guess it would be a sensible choice if you’re bearish and need the exposure.”

Target return

In conclusion, this adviser said that investors buying the notes may not be particularly motivated to be invested in emerging markets.

“The payoff for whom this is an interesting instrument is not the payoff you would expect from emerging markets exposure,” he said.

“This is not a note for someone who wants to bet on emerging markets. It's for someone looking for a higher return on a three-year, a return that's higher than comparable treasuries and who is willing to take some risk to get it.

“It's not a terrible risk. The buffer really helps. You do have some protection, but there is still downside risk.

“And you’re giving away a lot of the upside.”

BMO Capital Markets is the agent.

The notes settled on Monday.

The Cusip number is 06374VY42.

The fee is 0.1%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.