Bank of America's step-up autocallables linked to S&P 500 designed for range-bound market

By Emma Trincal

New York, Jan. 8 - Bank of America Corp.'s autocallable market-linked step-up notes due January 2016 linked to the S&P 500 index give investors an opportunity to outperform the equity benchmark in a flat market, but the downside barrier and the length of the notes present drawbacks, sources said.

If the index closes at or above the initial level on either call observation date, the notes will be called at par of $10 plus a call premium of 8.5% per year, according to a 424B2 filing with the Securities and Exchange Commission. The call dates will be in January 2014 and January 2015.

If the index finishes at or above the step-up value - 120% to 126% of the initial level - the payout at maturity will be par plus the index gain.

If the index finishes below the step-up level but at or above the initial level, the payout will be par plus the step-up return of 20% to 26%.

Investors will receive par if the index falls by up to 5% and will be exposed to any losses beyond 5%.

The exact deal terms will be set at pricing.

Virtually no protection

Tom Balcom, founder of 1650 Wealth Management, said that a 5% protection for that type of duration made the notes particularly risky.

"It's not for the weak-of-heart investor, especially on a three year," he said.

"The purpose of a structured product is to provide protection. Otherwise, you can just be long the index."

The notes do provide a way to outperform the market, he acknowledged, in the case of a market trading sideways as investors would benefit from the 20% to 26% digital payout in a "muted" market.

But two factors had to be taken into account, he said: the uncertain maturity as the notes can get called after one year and the fact that investors in the notes have to forego dividends, unlike their equity investor counterparts.

With the S&P index yield at about 2% and without taking into account compounding, an investor in the benchmark would earn 6% worth of dividends over the course of three years "without doing anything," he said.

"You'd have to think that the S&P will trade range bound over the next three years. I can't imagine the index staying flat over that period of time. If there is a nice rally, you're going to miss it. If the market is up, you'll get called.

"Look at last year: the market was up 16%. You would have underperformed by almost 50% getting only the 8.5% premium.

"Every note has a purpose. But I don't see what the purpose of this one is with a three-year holding period and virtually no downside protection.

"You can make money on the first year if you get called out due to a slightly up market. So maybe for a flattish market it could work.

"But if you're bullish or bearish, it's not a good note," he said.

Balcom said that the note was difficult to assess because the structure allowed for many different scenarios to occur with different payouts. The uncertainty around the actual length of the notes given the call feature added to the complexity, he said.

"These notes are also too complicated," he said.

"You want a product that gives you long exposure to the S&P 500 but with some protection against the downside risk," he said.

"This one is different. You don't get the downside protection, and you have to hold the notes for three years."

Capped by the call

A market participant examined three aspects of the structure: the 5% buffer, the fact that the upside was uncapped above the 120%-126% step-up value and the yearly call.

He found that the 5% protection was almost negligible.

"It's a three-year, but you don't have much protection. Five percent over three years, anything can happen," he said.

"It's the S&P, so you're not going to lose 100% of your money. But you're giving up a lot of protection for a potential 8.5% return."

He took two hypothetical scenarios.

"Case No. 1: It's year one, the S&P is up 15%. You get called out and make 8.5%," he said.

"Case No. 2: After one year, the market is down 15%. It's flat for the next two years. At maturity, you lose money for the opportunity of earning 8.5%."

A second feature, the absence of a cap at maturity if the index finished above the step-up value, may not be a real advantage, he said.

"The uncapped performance has no value because you can invest in the S&P and do the same thing. At the end of the day, the 5% downside protection is not much," he said.

The 8.5% call premium represented a more likely cap.

"The call scenario may not be pleasant. If the market rallies and goes up by 25%, the client gets redeemed at 8.5%. You, the adviser, may think it's great, but the client might not be happy. The notes may have been sold as an uncapped product, and the client may not have viewed it as an 8.5% per year return," he said.

Flat appeal

However, the notes were interesting in a range-bound market, this market participant said.

"You have a digital, so if the market is flat, you get the bump up, which is fine assuming that the step is priced closer to 26%," he said.

"It's only interesting because of that step up. If the market is flat, you have a pretty decent coupon."

But the protection offered is not much for the tenor of the notes. "It's a three-year. That's a long time," he said.

Overall, the drawbacks seemed to offset the appeal of the structure, he noted.

"The call is going to cap your upside. You have no downside protection for the most part. The uncapped part of the upside is only if the S&P rallies significantly within the final period," he said.

If the notes had offered a two-year call protection with a 10% barrier, this market participant would have been able to "understand" the rationale behind the product.

"But the fact that it's a callable note with this step-up feature plus the uncapped upside makes it more complicated," he said.

"I've seen other autocallables that have much greater downside protection."

He mentioned without being specific callable yield notes with 8% to 9% coupons and 60% barriers.

"They're not great. But you can get a much better protection than this one," he said.

Perhaps the problem with the structure was its hybrid nature - a mix of a step-up equity-linked product and an autocallable, he noted.

"To me, that step-up feature with the uncapped upside doesn't add that much value because they crush you with the downside protection," he said.

"A simple autocall would have been easier for the client to understand and probably an easier product to sell."

Bank of America Merrill Lynch is the agent.

The notes will price and settle in January.

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