Bank of America's Stars linked to S&P 500 offer lower risk with autocallable feature, buffer

By Emma Trincal

New York, Feb. 15 - Bank of America Corp.'s 0% Strategic Accelerated Redemption Securities due March 2014 linked to the S&P 500 index offer an annualized call premium of 4% to 7% when the index closes at or above its initial level on a quarterly observation date. Investors in this case receive their investment back and the trade expires.

If the final index level is at least 95% of the initial level, the payout at maturity will be par. Investors will be exposed to any losses beyond the 5% buffer, according to an FWP filing with the Securities and Exchange Commission.

The exact call premium will be determined at pricing.

"This is an autocallable, a structure that is not only aimed at delivering yield but at reducing risk in general," said Suzi Hampson, structured products analyst at Future Value Consultants.

"These notes do not offer a headline yield. But the risk is quite limited, which gives investors a fairly decent risk/return."

The coupon barrier for the product is the initial level. Investors at maturity enjoy a 5% buffer, which brings the maximum loss amount down to 95% instead of 100% with a barrier, she said.

Buffer

"Most autocall have barriers. We don't see many of them with buffers, so even if 5% is small, it doesn't hurt," she said.

But the buffer in this product is not the real risk-reducing factor, she said.

"Think about it: it's an autocallable, and if it gets to the end, if it missed three call opportunities, it means that three times in a row, the index has been below 100%. Realistically, if you are below 100 in three consecutive quarterly calls, it's unlikely that you're going to be above 95% at maturity," she said.

"It could be that the buffer doesn't cost much money and it makes it more marketable. For an investor, it shouldn't make a big difference if you think it through.

"Advisers may like it because it's always attractive to be able to offer a product that will outperform the index as it is the case here. Even if you take into account the fact that you're not getting the 2% dividends of the index when you buy this note, you're still going to outperform the index thanks to the buffer.

"Advisers can justify why they picked the product. Outperforming the benchmark comes into the picture.

"But what really reduces risk in this product compared to a growth product is not going to be the buffer. It's the potential early redemption. When you think about it, a note, if it gets called, gives investors 100% of their money back. The risk is zero at this point. The more likely a note is to be called, the more likely it is to be risk free.

"Of course you have reinvestment risk. If you get called on the second quarter, nothing guarantees that you're going to get a rate comparable to what you had six month before.

"But most of the time, investors in an autocallable hope to get kicked out so they can reinvest in a different product."

The low-risk nature of the structure is reflected in the riskmap, Future Value Consultants' measure of the risk associated with a product. The higher the riskmap on a scale of zero to 10, the higher the risk of the product. The score is the sum of two risk components: market risk and credit risk.

The riskmap for this product is 2.45, compared with 4.04, for the average of all products.

What contributes the most to the low riskmap is the subdued market risk in this product, she noted.

At 1.99, the product's market riskmap is less than 3.38, the average score for all product types.

"The market risk is much lower than all products, which is not so much the result of the buffer - many leveraged notes often have a one-year term with a 5% to 10% buffer - but because you have the three opportunities to get your capital back. When you have three opportunities to exit early with your money back, it reduces risk down to zero. It's an important difference with growth products," Hampson said.

Autocall and risk

The call feature explains why a product with such a small buffer would be less risky than a leveraged note or a reverse convertible.

"It makes no sense to compare this 5% buffer with a 5% buffer you would get in a one-year leveraged note tied to the S&P 500. You can't either compare it to shorter notes tied to stocks," she said.

"It's hard to evaluate how much risk reduction you get with three kick-outs plus a buffer. It's probably quite considerable."

The market riskmap is also lower than the average of the same product type of 4.12.

"Some autocallable products are linked to anything including single stock or different indexes that are much more volatile than the S&P 500. They can also be a little bit longer or have different autocallable levels," she explained.

"Here you have three autocallable dates; the level is 100; plus you get the 5% buffer. I'm not surprised it's at the low end of risk."

The autocall reduces market risk by definition. But it also introduces reinvestment risk. Investors may get their principal back six months after issuance but may not find the same interest rates available out there.

Investors in those products have to accept the risks involved with early redemption.

The other component of risk, the credit risk map, is also very small at 0.46, compared with 0.65 for the average of all products.

"Bank of America is at the riskier end of the credit risk spectrum, but at the same time it's only one year, so one factor of risk is canceled out by another," she said.

Compared to a lot of capital-at-risk products, the notes have a lower risk profile. However, investors can still incur "huge" losses, she said.

"You can't really say that it's designed for cautious investors. You couldn't sell it to investors who wouldn't be ready to lose some capital. Instead, this is a product that's aimed at people looking to reduce the S&P risk. They just want less risk," she said.

"They also like the idea of a target return rather than participating in the growth of the index. You still have the cap, but there's a much higher chance of getting the cap."

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, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The probability table of return outcomes calculated by Future Value Consultants showed that investors have a 70% probability of getting a return comprised between 5% and 7% per annum.

The return score for the notes is 6.57, roughly the same as all products (6.54) and slightly higher than issues of the same product type (6.46).

"You do have the opportunity to get your principal back three times. It's less risk for the investor. That's why you have a lower cap than you would have in a growth product," she said.

"It's very average. Although the riskmap is more, the return is also lower. The balance between risk and return is comparable with other products available in the market. You would get a higher return if you were ready to invest in a higher risk product. In this case the return fairly represents the risk. We know intuitively that less risk will give you less return, and this is what the score illustrates. It's reasonable."

Price, overall

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. 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 call premium is given in a range, which is a little bit less reliable," she said.

According to its methodology, Future Value Consultants chooses a cap or coupon situated 25% below the higher end of the range, which would be 6.25% in this example, she said.

"There's a difference between a 3% and a 7% coupon. The final call premium is obviously going to be very important and will impact the final price score. It will make a big difference. Setting the final premium will depend on how the market moves. If we see a sudden volatility pickup prior to pricing, we should expect the coupon to go up."

The price score based on the hypothetical 6.25% call premium is 7.49. It's more than the 7.32 price score for similar products. It's also higher than the 6.74 average price score of all products.

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

At 7.03, the product received a higher overall score than its peers, whose average score is 6.89. The overall score is also better than all products, which have an average score of 6.64.

"These return, price and overall scores simply mean that there's nothing here to tick you off," she said.

"It's not an out-of-this-world product, but it's fair. The structure is appealing if you want to change the risk/return profile and make it less risky than a direct market exposure. It's not a glaring negative score that would put you off. It's average. That's what those scores are all about. You want to stay away from what's below average."

The notes will price and settle in February.

BofA Merrill Lynch is the agent.

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