Bank of Montreal’s leveraged notes tied to SPDR Dow Jones REIT target mildly bullish investors

By Emma Trincal

New York, March 8 – Bank of Montreal’s 0% buffered bullish enhanced return notes due March 29, 2018 linked to the SPDR Dow Jones REIT exchange-traded fund give access to the REIT asset class to skittish investors who do not anticipate high returns in the underlying fund, said Tom Balcom, founder of 1650 Wealth Management.

The payout at maturity will be par plus 150% of any fund gain, up to a maximum redemption amount of $1,195 for each $1,000 principal amount, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to 10% and will lose 1% for each 1% decline beyond 10%.

Income stream

“We do like the sector,” said Balcom.

“Most REITS have leases adjusted for inflation, which offers some protection against higher interest rates. Of course, it will cost REITs more to refinance their debt, but it’s offset by the built-in hedge against inflation, which makes those investments attractive if you want a stable income stream. It’s a nice diversifier to have in the portfolio.”

The main appeal of the structure is on the downside, not on the upside as the cap limits the annualized return to 9.32%.

Low cap

“That’s not a very high cap. In the past month this ETF is already up almost 12%,” he said.

“It’s not a bullish play. If you’re bullish, you’d want no buffer, two-times leverage and a higher cap level.

“This is more for someone who wants exposure to the sector with a degree of downside protection. Keep in mind that the first two months of this year have been very volatile.”

The price dropped 12% from the beginning of the year to Feb. 11 when it hit its low. It has rallied by the same amount since.

“If I’m kind of scared about the underlying but still want exposure for the benefits associated with REITs, that may be a way to do it rather than going long only,” he added.

Buffer

The leverage helps offset one of the disadvantages of investing in a structured note.

“You’re not really buying it for the leverage. The leverage compensates for the yield you’re giving up, which is 3.33%. What is more attractive is the 10% buffer,” he said.

Balcom said he gets exposure to REITs through structured notes linked to funds “similar to this one” –naming the Vanguard REIT Index ETF and the iShares Dow Jones US Real Estate ETF – but he uses a different structure.

“We have exposure to REITs through twin-win notes. We like it because you can make money on the downside as well. But those deals are based on barriers. This one has a buffer. It’s more appropriate for a more conservative investor,” he said.

Twin win is a different terminology for absolute return products.

Early bear

Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments LLC, argued that the 10% buffer would probably not be enough to protect against possible “big drops” in the share price. He is bearish on the fund.

“In the past four and a half years, this ETF has doubled in price and so the yield is much lower than what it is historically,” he said.

“People still like it. They look at the relative yield, comparing it with what’s out there instead of looking at its historical value. In this low interest rate environment, the dividend looks attractive. Most people do that. I don’t think it’s the right way of investing though,” he added.

Looking at a chart, he noted that the fund’s share price doubled from October 2011 to January 2015. Since then, the price is showing a downward pattern.

“You have something that has been on a bull trend for four or five years and now it’s showing lower lows. A downtrend can also last a few years. It might not reach its lowest point until 2018. From a technical standpoint, I don’t like the timing of this trade,” he said.

Too crowded

Another factor of concern is that investors getting exposure to REITs probably do so for the wrong reasons.

“They go to their bank where they’re being told it’s a good way to get income. People who buy those things are not knowledgeable about real estate. They’re just chasing yield, and they probably think it’s as safe as having money in the bank without realizing they can suffer big drops,” he said.

“This is the typical crowded trade. It’s always dangerous to invest along with misinformed investors who don’t realize the risk they’re taking.

“As losses begin to accumulate, they panic and back out in droves. That’s why I don’t think a 10% buffer is enough in this case.”

BMO Capital Markets Corp. is the agent.

The notes will price on March 28 and settle on March 31.

The Cusip number is 06367TBK5.

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