Bank of Montreal's digital notes linked to fund offer too little return given risk, volatility

By Emma Trincal

New York, April 5 - Bank of Montreal's 0% buffered bullish digital return notes due April 30, 2015 linked to the iShares FTSE China 25 index fund, despite a 10% buffer against downside risk, present risk due to the implied volatility of the fund, said Suzi Hampson, structured products analyst at Future Value Consultants.

As a result, her firm's ratings showed a low risk-reward profile for this product along with a below-average price score.

If the fund return is positive, the payout at maturity will be par plus a digital return of 11%, 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%.

"This is a capital-at-risk product with a more volatile underlying than the market, and as a result, you would expect a higher payout because you're taking on more risk," Hampson said.

The one-year implied volatility on this fund is 22% versus 16% for the S&P 500 index, she noted.

"There's a significant difference."

Market risk

Future Value Consultants rates the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

"One positive aspect is the very low credit risk. Bank of Montreal is one of the lowest credit risk issuers," she said, commenting on the 0.22 credit riskmap for the product versus an average of 0.81 for the same product type, or other digital notes.

On the other hand, she noted that the market riskmap of 2.78 was comparable with the 2.70 average for the product type.

The combination of those two risk factors showed a riskmap of 3 for the notes versus an average of 3.52 for the same product type.

"The credit risk is well below average, whereas the market risk is average. The riskmap is lower than the average of the same product type," she said.

"But the riskmap on its own doesn't really give you the whole picture because if it's the market risk you're worried about, this is actually average risk.

"The 10% buffer seems reasonable at first. But when you look at the volatility of the fund, you realize that 10% is probably not enough to reduce or eliminate the risk on a two-year period."

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull- and bear-market scenarios and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

"With an average market risk product, you would expect to get an average return comparable to the rest of the market," she said.

The 6.56 return score for the notes, however, is "much lower" than the 7.30 average for the same product type.

"The low return score suggests that you're not getting the same payout as similar products in the same risk bracket," she said.

"You want to compare the notes with products with similar risk. But you could do that with a less volatile underlying, such as an S&P-based product, which would have a similar risk rating due to a smaller buffer for instance.

"We do get a 10% buffer, but the product is based on a volatile underlying. Even though it has a buffer, it has the same risk profile as a product with a smaller buffer."

For investors trying to select a product among others based on the return score, Hampson recommended that they pay attention to average scores.

"You want average or above average. The low return score here suggests that for this risk level you should be getting higher returns," she said.

"Or you may want a less risky product with similar returns.

"We've considered the best market scenario with the bullish assumption. But how bullish doesn't really matter since you have a fixed payout.

"Investors considering this note are interested in getting paid a fixed return. They expect a small to moderate market growth. If you were really bullish, you would be better off with an enhanced participation product. But here, with the digital, you don't need much growth to get the maximum. You want a flat or mildly bullish market and then get your fixed payout of 11%."

Some investors may consider the notes as an alternative to a direct investment in the fund.

"Technically, you could always buy the shares in the fund. But the risk return would be different. The buffer in the notes will reduce your capital at risk. If the fund declines by less than 10%, you get your capital back. If it drops by more than 10%, you lose less than the fund. In exchange for the buffer, you pay this cap," she said.

However, the price score indicated that investors were paying a lot for the buffer, she noted.

Price, overall

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes showed a 5.54 price score. In comparison, the average digital product had a 7 price score. Even the "all product types" category, which is heavily populated by reverse convertibles and tends to score lower, revealed a higher average price score of 6.68, she said.

"The price score is very low. The average for this type of product is 7. This is 5.5," she said.

"The fund pays a 2.65% dividend, which you're not getting. That's 5.3% for the two-year term. If you subtract that from the 11% digital payout, you can see that they're not really offering very high returns.

"The price score well under average suggests we should expect the issuer to offer a higher coupon for this product given the risk and the volatility associated with the underlying fund."

Future Value Consultants, with its overall score, offers its opinion on the quality of a deal. The score is simply the average of the price score and the return score.

The overall score for the notes is 6.05, compared with 7.15 for the same product type. The average score for all products is 6.63.

"With a not-so-great return score and a bad price score, you're getting an overall score that is quite below average," she said.

"It's even less than the average for all products. This is not favorable.

"It's possible that some investors may be drawn to the product because credit risk for them would be a concern. In this case, Bank of Montreal would make sense. It's a very good credit.

"But you could invest in the fund. You're still taking a risk.

"Obviously the buffer makes it a lower risk option than the fund, but it just doesn't seem to pay enough."

The notes (Cusip: 06366RNJ0) are expected to price April 25 and settle April 30.

BMO Capital Markets Corp. is the agent.

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