Bank of America to price two relative value notes seen as vulnerable to Fed policy shift

By Emma Trincal

New York, March 28 - Two separate notes based on relative value trades announced by Bank of America Corp. are seen as speculative bets, especially if the Federal Reserve Board changes course and raises interest rates, sources said.

In one of the notes, investors' returns are based on the relative performance of gold versus the dollar; in the second one, gains rely on whether the S&P 500 outperforms 20-year Treasuries.

Gold versus dollar

Bank of America plans to price one-year 0% Relative Value Strategic Accelerated Redemption Securities linked to the performance of the SPDR Gold trust versus the PowerShares DB U.S. Dollar Index Bullish fund, according to an FWP filing with the Securities and Exchange Commission.

If the performance of the SPDR trust exceeds the performance of the PowerShares fund on any of three call observation dates, the notes will be called at par of $10 plus a premium of 11% to 15% per year. The observation dates are expected to fall in October 2011, January 2012 and April 2012. The exact premium and dates will be set at pricing.

If the notes are not called, the payout at maturity will be par plus the difference of the SPDR trust return minus the PowerShares fund return. Because the last call observation date is also the final valuation date, if the notes are not called, the return will be negative and investors will lose principal at maturity.

"It's a speculative bet on gold against the dollar. A lot of factors are driving the price of gold besides currencies. And gold could go up, or it could get slaughtered. It's a very volatile asset class," said Steve Doucette, financial adviser at Proctor Financial.

"A gold bug would continue to buy gold. But this is tied to gold minus the dollar. I don't know if I would marry the two.

"It's a pure bullish play. If you're wrong, you don't get the return and it's a pure negative."

For Greg Salvaggio, senior vice president of capital markets at Tempus Consulting, the rationale of the underlying trade is in line with a bullish view on gold. But he does not share that view, saying that gold is due for a correction.

"It makes sense. This is a pretty straightforward trade. You look at the performance of gold versus the dollar. If the gold price is greater than the movements of the dollar, you get paid.

"It's for people who are very bullish on gold. You take advantage of a weak dollar. You are betting that gold and the dollar will move in opposite directions," he said.

Fed wildcard

The trade becomes risky if or when the Fed decides to raise rates, he said, because a Fed hike would cause the dollar to strengthen. So far, the rise in gold has been supported by a weak dollar, so there is always a risk of a gold sell-off if this trend reverses, he said.

Salvaggio noted that investors in the notes would have to be extremely bullish on gold and unconcerned with moves in the dollar.

"You basically believe that gold will accelerate really primarily as an inflation hedge and independently of what the dollar does. It's more a view on the price of gold than on the price of the dollar," he said.

What is more of a risk, he said, is the bullish bet on gold itself.

"It's a fair trade. But I personally think gold is way overbought at this point. I would sell it rather than buy it," he said.

Equities versus bonds

Bank of America announced another deal with nearly exactly the same terms - same tenor, same call premium and same observation dates. The difference lies in the underlying, which is the performance of the SPDR S&P 500 ETF trust versus the iShares Barclays 20+ Year Treasury Bond fund.

If the equity benchmark performance exceeds the performance of the Treasury fund on the observation dates, the notes will be called at par of $10 plus a premium of 11% to 15% per year.

The observation dates are expected to fall in the same months of October 2011, January 2012 and April 2012.

As with the other deal, in the absence of a call at maturity investors will lose principal.

'A perfect storm'

Doucette said that investors in the notes are bullish on stocks and bearish on Treasuries. But he questioned whether the two views can be reconciled in a rising interest rates scenario.

"A lot of people think the Treasury market will get hit hard either because the Fed will raise rates or because interest rates will creep up. Either way, it's a good outcome for people who are bearish on Treasuries," he said.

"But with these notes, you also have the other side of the trade: You have to be bullish on equities too.

"If interest rates go up, it doesn't help the stock market very much either.

"It's a perfect storm between those two competing forces, and it looks too speculative to me."

Moderate hike

Salvaggio said that an equity sell-off as a result of a rate hike is not automatic. It could be avoided if the Fed acts in ways that would not destroy investor confidence.

"The Fed will shift its bias and raise rates, prompting a bond sell-off. But it won't raise rates high enough to hurt stock prices, so equities will continue to rally. This note is for people who have a bearish outlook on bonds and a bullish outlook on stocks," he said, adding that the two views can be held simultaneously depending on how moderate and gradual the Fed policy shift is implemented.

Both notes will price in April and settle in May.

Merrill Lynch, Pierce, Fenner & Smith Inc. is the agent.

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