BMO’s $4.66 million absolute return notes on S&P may not meet bulls’, bears’ convictions

By Emma Trincal

New York, Sept. 7 – Bank of Montreal’s $4.66 million of 0% contingent risk absolute return buffer notes due Feb. 27, 2026 linked to the S&P 500 index may not show adequate return potential for either bulls or bears, according to advisers.

If the index finishes above the initial level, the payout at maturity will be par plus 1.25 times the index gain, subject to a maximum return of par plus 21.5%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index declines by no more than 20%, the payout will be par plus 1.25 times the absolute value of the index return.

Otherwise, investors will lose 1% for each 1% decline beyond 20%.

Low caps

“You’re only outperforming if the market is flat or down. You may catch the 1.25 leverage, but either way you’re capped out. If the market is up, you quickly get capped out,” said Steve Doucette, financial adviser at Proctor Financial.

The maximum absolute return on the downside when applying the 1.25 multiple would be 25% over the two-and-a-half-year period. This downside cap slightly exceeds the 21.5% maximum gain on the upside.

Those levels represent an annualized compounded return of 8% on the upside and 9.35% on the downside.

“The cap doesn’t deliver much return on an equity derivative. Even the leverage of the absolute return doesn’t give you enough to get excited,” he said.

Buffer

Doucette admitted that investors would outperform if the index finished negative regardless of the market decline.

“You would outperform if you stay within the buffer range. If you go beyond that, if you’re down 25% for instance, you would only lose 6.25%. That’s the neat part,” he said.

But this was not enough to make the payout attractive, he said, because the potential gain on the upside was too muted.

Negative assumptions

The note required some level of bearish conviction, which Doucette said he lacked.

“You assume the market is going to be down between 0% and 20% over the next two-and-a-half years. I can’t imagine that kind of scenario over that period. What are the odds? This is narrow. I can’t put a high probability on that. I wouldn’t venture down that road,” he said.

Not a pure hedge

If Doucette’s bullish take on the market made the note unappealing to him, a bearish investor may not find the payout attractive either.

“If you’re bearish or if you simply want to put a hedge on your portfolio, there are smarter ways to hedge,” he said.

“I would give up the upside and give myself more return on the downside.

“This note is really designed for a bearish play. But the issuer tried to give you something on the upside too. Unfortunately, the upside cap is too low. You might as well change the profile of the note and make it a real hedge.”

Equally disappointing

Restructuring the note as a hedge made sense although it would not match Doucette’s market outlook.

“If inflation is under control and the Fed stops hiking rates, do you really think the market is going to be down 20%? I don’t. But if you do, increase the buffer on the downside, or even better, make it a one-to-one inverse participation and get rid of the cap on the absolute return.

“I wouldn’t know exactly how to restructure it until I look at the numbers. And since I really don’t have this bearish conviction, I wouldn’t even look at it,” he said.

“I’m just saying: if you’re a bear, this note is not bearish enough; and if you’re a bull, the 8% a year is not going to make you happy.”

Likely breach

Another financial adviser said the buffer size was not wide enough. His outlook was very bearish.

“I expect the S&P to drop by at least two-thirds. That’s in line with other past bear markets. It’s actually conservative given how ridiculously overpriced the market is. We’re also coming from the longest bull market in history,” he said.

The S&P 500 index on the trade date closed at 4,514.87.

According to this adviser’s view, the market could very well bottom at around 1,500.

“Even if the market had a huge rebound, let’s say if it doubled from 1,500 to 3,000, it would still be down below the buffer. You’re still going to lose out,” he said.

A less severe drawdown, such as 45% for instance taking the index to 2,500, would still cause investors to lose money.

“I doubt that the recovery could take you back above the buffer level,” he said.

The 80% buffer level sets the buffer price at 3,611.9.

Even in a less bearish scenario – a 45% drop to 2,500 for the index, a recovery bringing the index price back above the threshold would be unlikely, he said.

“This note may have been designed for a range-bound market. But it’s not going to work in a bear market,” he said.

BMO Capital Markets Corp. is the agent.

The notes settled on Aug. 31.

The Cusip number is 06375M5X9.

The fee is 2.5%.

© 2015 Prospect News.
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