BMO to offer two notes linked to emerging markets ETF with different risk, return profiles

By Emma Trincal

New York, Dec. 19 – Bank of Montreal plans to issue two offerings giving investors exposure to the emerging markets in very distinct ways. Both issues have the same underlying exchange-traded fund and a two-year tenor.

The first product, leveraged and buffered, offers conservative access to the asset class. The second, riskier in nature, gives investors uncapped exposure to the upside with absolute return on the downside.

Two deals

BMO’s 0% buffered bullish enhanced return notes due Dec. 24, 2018 linked to the iShares MSCI Emerging Markets exchange-traded fund offer 1.5 times any ETF gain up to a 14% cap. The downside will be protected by a buffer of up to 26% to 29%. The final buffer size will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

BMO’s 0% contingent risk absolute return notes due Dec. 24, 2018 linked to the iShares MSCI Emerging Markets ETF will offer at maturity par plus the gain, according to a 424B2 filing with the SEC.

If the fund falls but never closes below the 68.5% to 72.5% barrier level during the life of the notes, the payout will be par plus the absolute value of the return.

Otherwise, investors will be fully exposed to any losses.

Bullish and not bullish

“With the first one, you’re getting less than 7% a year compounded. It’s just not enough for the risk. It’s a good buffer, but if you own emerging markets, you have to be optimistic,” said Jerrod Dawson, director of investment research at Quest Capital Management.

Dawson said he has some exposure to emerging markets.

“I have a positive view on emerging markets. Valuations are favorable. It’s historically cheap relative to developed markets. We own it for the long term. We’re market weight in this space,” he said.

From that standpoint, the second offering makes more sense because it provides unlimited upside.

At the same time, the barrier’s contingent protection of 27.5% to 31.5% is “a pretty meaningful barrier for a two-year,” he said.

American

However, this barrier is not the classic “European” barrier, which is observed point to point. This one, a so-called “American” barrier, can be breached any day, which makes the protection slightly weaker as the chances of a barrier event occurring are much greater.

The cushion size and absolute return of the second offering would have been attractive with a normal barrier. But the daily monitoring adds a substantial amount of risk.

Absolute return

Tom Balcom, founder at 1650 Wealth Management, said that he prefers the first deal.

“We typically use European options. It’s less risk,” he said.

His choice is based on the barrier type. If the second note had featured a European barrier, it would have been his choice. The main reason is the absence of a cap on the upside.

A second reason behind his inclination to prefer the second offering is the absolute return.

“The market is down 20%, you have a 10% buffer, client loses 10%. Chances are they will still be unhappy. But when they can make money if the market is down, they love it.”

The first note could fit the needs of a particular class of clients.

“The cap is really low, but the buffer offers a strong protection. If you have conservative investors who want exposure to emerging markets, the 26% to 29% buffer gives you a lot of leeway in case there is a pullback.”

Strong barrier

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he would not consider the second note with the barrier.

“It’s a significant barrier, and the odds to breach are not even great. You’re looking at a 5% chance of breaching a 27.5% over a two-year period,” he said based on statistics he computed on the index since 2003.

“But once it breaches, you lose everything. You’re guaranteed to underperform since you don’t have the dividends and you lose the absolute return too.”

Too risky

The odds of losing money are much higher due to the American option. For that reason, he would not consider the notes.

“For us, the barrier is the deal-breaker,” he said.

“It’s an American barrier. You lost me on that fourth bullet point.

He was referring to the prospectus, which stated that a barrier event can occur on any trading day.

“You’d have to worry about it every day. I can’t account for that level of risk.”

Buffer

On the other hand, the leveraged buffered note offers tangible advantages.

“The downside protection is huge, and it’s a buffer. Getting a 26% to 29% buffer on a two-year is great,” he said.

“Even on the S&P it’s really hard to get that type of buffer on a two-year.”

In order to assess the value of the buffer, he looked at the probabilities of the underlying generating a negative return over a two-year trailing period. He compared the emerging markets ETF with the S&P 500 index. He found a 37% probability for the ETF to finish negative. For the S&P 500, the probability was 19%.

“There is no doubt that emerging markets are much more volatile. But the buffer is still huge.”

Cap

He then assessed the chances of the ETF hitting the cap on the upside, based on two-year trailing period statistics.

He found that 47% of the time, the emerging markets ETF would generate a gain in excess of 14% after two years.

“You’re going to cap out almost half of the time,” he said.

Putting those two results together – a very low probability of losing beyond the buffer and a high chance of hitting the cap – he concluded that terms may have to be reconfigured.

Value

“It seems like the buffer is so big that the chances of you benefiting from it are small. But the cap is too low. The chances of being capped out are too high,” he said.

A 25% cap for instance would be hit only 25% of the time instead of 47%, he said.

“It would be a much more decent cap.”

If the cap were raised in exchange for a smaller buffer, the notes would offer greater value, he said.

“You’re paying a lot for a buffer that you may not fully need. I would try and increase the cap,” he said.

In spite of this pricing issue, this note would be his preferred one versus the barrier note.

“We do a lot of active equity management in emerging markets. I could use the notes as a complement to an actively managed portfolio in this asset class. If you want to dial down the risk, it would be a nice addition.

“This is not a good standalone structure. But I can see myself using it paired with our own active management.”

BMO Capital Markets Corp. is the agent for both offerings, which will price on Tuesday.

The Cusip number for the buffered deal is 06367TQD5, and it is 06367TQC7 for the absolute return notes.

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