Bank of Montreal’s leveraged notes tied to Russell offer good value, fair risk-reward profile

By Emma Trincal

New York, Sept. 5 – Bank of Montreal’s 0% buffered bullish enhanced return notes due Sept. 30, 2016 linked to the Russell 2000 index offer investors an average risk-adjusted return and competitive pricing, partly due to the use of a leveraged buffer on the downside, said Tim Mortimer, managing director at Future Value Consultants.

If the index return is positive, the payout at maturity will be par plus 200% of the index return, subject to a maximum return of 22%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by 10% or less and will lose 1.1111% for every 1% that it declines beyond 10%.

“You have a double participation with a cap of 22%, which means getting the maximum return only requires the index to grow by 5.35% a year,” Mortimer said.

“It’s a hard buffer, but with the gearing, the final value at maturity could get down to zero.

“The Russell has a reasonable volatility, so you’re actually getting a significant buffer with a 10% on two years.”

Downside leverage

Buffers with downside participation are not “unheard of,” he said, although they are less common.

He explained how the 1.1111 leverage factor is calculated.

“These buffers are structured in a way that enables a 100% loss of principal. You must be able to lose 100% of your principal over a 90% to 0% decline; in other words, the factor is going to be 100 divided by 90. With the gearing, if the index goes down to zero, you get zero. With a normal buffer, you would get 10% back. So with the downside participation, your principal goes down a little bit quicker,” he said.

This additional risk in turn gives the issuer more room to improve the terms.

“If you are exposed to a little bit more loss on the downside, it means you’re taking on a little bit more risk,” he said.

“Therefore, some extra premium can be used in the structure. The extra benefit would have to go somewhere – either in the form of a better buffer or a higher cap.”

The downside gearing applied to a buffer makes some investors “nervous,” he said.

“But if you compare a geared buffer with having no protection at all, which is being long only, you are always better off with the geared buffer,” he said.

The comparison between such buffer and a barrier would depend on the barrier level and the buffer amount.

“In general, a barrier is problematic because once it’s breached, it goes away, unlike a buffer that’s always there,” he said.

He offered a hypothetical example with three notes that are similar except for their downside protection mechanism. The first product would offer a 10% buffer with one-for-one participation beyond the threshold. The second note would be similar to the Bank of Montreal product with a 10% buffer and a 1.1111 downside leverage factor. Finally, the third note would feature a 20% barrier.

In Mortimer’s example, the underlying index finishes down 20%. In the first deal with a standard buffer, investors would lose 10%. They would lose 11% with the geared buffer. But with the barrier notes, the loss would amount to 20%.

“This example shows that a geared buffer is slightly worse than a regular buffer but a lot better than a barrier once the barrier is breached,” he said.

Riskmap

Future Value Consultants measures the risk associated with a structured note with its riskmap. The rating is on a scale of zero to 10 with 10 being the highest level of risk. The riskmap is obtained by adding its two sub-components: market risk and credit risk.

The market riskmap of the notes is 2.52, compared with an average of 2.87 for products of the same type, which in this case is the leveraged return product type, and an average of 2.92 for all products recently rated by Future Value Consultants, according to the firm’s research report.

“The market riskmap is lower than the average of all products and also lower than the average of the same product type,” he said.

“It’s probably because a 10% buffer, even with the leverage, is still better than any barrier,” he said.

The credit riskmap is 0.21, compared with an average of 0.57 for products of the same type, the report showed.

“The credit risk is low. Bank of Montreal is a good credit,” he said.

“You see significantly less credit risk and less market risk than the market, so the overall riskmap is also less than average.”

The riskmap is 2.73, compared with an average of 3.44 for the product type.

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. 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 product has an 8.56 price score, compared with an average of 7.57 for products of the same type.

“This is a high price score,” he said.

“It’s pretty competitively priced. The Russell is the second most common U.S. index. In addition, it’s a plain vanilla structure. You would expect pricing to be competitive, and that’s what you have.”

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 markets, and high- and low-volatility environments.

The return score is calculated based on the best among the five return scenarios, which for this particular product would be the bullish scenario.

The notes have a 7.69 return score, which is nearly the same as the average for the product type at 7.71.

“The return score is reasonable. It’s the same as the product type. In a moderately bullish scenario, you still have a good chance of achieving a good return,” he said.

“Investors in this note would be moderately bullish on this underlying index and would show a medium risk profile on the downside.”

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The overall score for the notes is 8.13, compared with an average of 7.64 for leveraged return notes.

“This is an excellent score. For the most part, the overall is driven by the value of the product as measured by its high price score,” he said.

BMO Capital Markets Corp. is the agent.

The notes are expected to price Sept. 25 and settle Sept. 30.

The Cusip number is 06366RWC5.

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