Bank of America's Mitts tied to Dow Jones Industrial: full principal protection, market upside

By Emma Trincal

New York, Dec. 1 - Bank of America Corp.'s recent sale of Market Index Target-Term Securities linked to the Dow Jones Industrial Average suggests that investors continue to have an appetite for principal protection, especially when given the chance to participate in the appreciation of the U.S. stock market, sources said.

Bank of America priced $51.15 million of 0% "Mitts" due Dec. 2, 2014 linked to the Dow Jones Industrial Average, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus the index return, subject to a floor of par and a maximum return of 67%.

The issuer said it applied to list the notes on the NYSE Arca under the symbol "MMF."

Simplicity

"I like this product. It's very simple. You get your upside up to a point and you get your principal protection subject to credit risk," a market participant said.

"Clients can understand it and it's very easy. If the Dow is up 20% at maturity, I get 20%. If the index is down and the issuer is still around, I get paid back. It's a very nice way for investors to participate in the upside of the equity index. In theory you could pick up 12% a year."

Dow Jones versus S&P 500

Most equity-linked notes reference the S&P 500 rather than the Dow Jones Industrial Average. But some said that the use of the Dow Jones index as an underlying for notes is not a novelty for Merrill Lynch.

"Merrill has been issuing Mitts for years and years and years," said Scott Miller Sr., managing partner at Blue Bell Private Wealth Management in Blue Bell, Pa. "It's not the first time that Merrill issues notes based on the Dow. I don't know why other firms don't do it as much. But Mitts is not new."

In the sector of Federal Deposit Insurance Corp.-insured products, the use of the Dow Jones Industrial index as the referencing index is widespread as well.

"You have a lot of equity products linked to the Dow Jones, but it's mostly in CD format rather than notes. This product competes with a CD. You take a little bit of credit risk but the flip flop is you get more upside," said the market participant cited earlier.

A sellsider familiar with the offering said about the use of the Dow Jones rather than the S&P in the deal: "It's all based on client interest. It's true that the S&P 500 is a broader index and is the main benchmark for equity. But sometimes, clients want something else."

The sellsider added that the goal was not to provide investors with diversification away from the S&P 500 index since "the correlation between the Dow and the S&P is almost perfect."

Volatility is another factor behind the use of the Dow, said an investment consultant. "There are only 30 stocks in the Dow Jones Industrial index versus 500 in the S&P. Maybe Bank of America wants something that is more volatile," said Bill Thatcher, senior consultant at Hammond Associates in St. Louis.

According to Future Value Consultants, the annualized volatility of the Dow Jones index in this structure is 40.23%. In comparison, the S&P 500 annualized volatility for another Bank of America's Mitts five-year product due Oct. 31, 2014 and linked to the S&P 500 was only 32.98%.

Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management in Atlanta, said that "Among the financial adviser community, the S&P 500 is the index that is the most widely followed and it's the public that follows the Dow Jones," adding that "the investment community recognizes that the Dow Jones is less representative than the S&P."

Playing with cap

According to Miller, this new Mitts offering differs from prior versions.

"It has a 67% and a 100% participation rate. In the past, Mitts were issued with no cap but with a 90% or 95% participation rate," he said.

The market participant said that such change of structure was probably related to the implied volatility of the underlying.

"Since the Dow is more volatile, it's more price-efficient to introduce a cap," said this source. "When you cap the return, you buy a call option for the appreciation up to the cap and after that, you sell the option. So it's a buy and a sell of an option that can help you mitigate the cost," he said.

The structurer can indeed sell the call option at the capped level because beyond that, the investor no longer participates in the index gains, he explained.

On the other hand, continued this source, in the absence of a cap and with a 95% participation rate, there is only a call option purchase with no sale to offset the cost. "In a high volatility environment, merely buying the option is going to be more expensive because the cost of the option is higher. The higher the volatility, the more expensive it is to buy the option," he said.

Liquidity concerns

Miller pointed to some of the drawbacks of the deal.

His first objection was the length of the term resulting in some reduced liquidity.

"I wouldn't recommend it to my clients," Miller said. "It's a little bit too long. A lot could happen in five years."

More specifically, Miller said that the notes may not be attractively priced in the secondary market especially in a rising market.

"Since it's a five-year, you can sell it in the secondary market. But if the market went up 30% in the next two years, the price of your investment would go up substantially less. That's because it's a point-to-point structure and so what happens in between is almost irrelevant."

His view was shared by the market participant who said that "If along the way you want to try and sell it early, you will not be participating one for one in the upside," invoking two reasons - the five-year term and the cap.

"It's only as you get closer to maturity that you get a return close to your appreciation up to the cap. The further you are from maturity the more you will see a gap in price," he said.

Fees

Miller also said that one of the reasons he would not be interested in the deal was because of the 2.5% fees.

"The expenses are a little bit too high. We are a fee-only shop. It's not as attractive to me. It's more of a commission type of product," he said.

"Fees are fees," said the market participant. "You get to pay fees and I don't think it's unreasonable for a five-year. Think of a mutual fund where the fee could easily be double that. Here you're giving up dividends and accepting a cap. And in return you're getting downside protection from Merrill Lynch. That's the trade."

ETNs and Mitts

Miller said that the product was somewhat comparable to an exchange-traded note product, but with less liquidity.

"This new issue is a retail investment because it has a trading symbol [MMF], which proves that Merrill brokers sold it to the public. It's similar to an ETN. But the ETN would tend to trade closer to the market because an ETN is much more liquid than this," said Miller.

In conclusion, Miller said that an ETN would be a better investment in a rising market.

"But if the market went down, the Mitts would have the principal protection advantage and you would be happy to get your money back," he said.

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