Bank of America’s $44.44 million STEP Income notes tied to Delta seen as indirect play on oil

By Emma Trincal

New York, Nov. 5 – Bank of America Corp.’s $44.44 million issue of 10% STEP Income Securities due Nov. 13, 2015 linked to the common stock of Delta Air Lines, Inc. was seen as an income play for investors bullish on the stock as well as on the airlines sector.

Additionally, the notes may fit the macroeconomic view that oil prices are far from recovering from their current lows, a factor that many see as bullish for Delta and the sector, a market participant said.

Interest is payable quarterly at a rate of 10% a year, according to a 424B2 filing with the Securities and Exchange Commission.

If the stock finishes at or above the step level of $43.16, 110% of the initial price, the payout at maturity will be par plus 6%. If the stock finishes at or above the initial share price but below the step level, the payout will be par. Investors will lose 1% for every 1% decline in the stock.

Bullish

The share price was $39.24 when the deal closed last week on Thursday. The stock rose 6.7% in the week that followed, closing at $41.87 on Wednesday, near its 52-week high of $42.86.

So far this year, Delta’s stock price has gained 52.5%. Since its third-quarter earnings announcement in mid-October, the company’s stock has risen by more than 25%.

“This note is a bet that the stock is going to trade sideways,” a market participant said, noticing the strong rise.

“You don’t expect the stock to jump up, otherwise you would buy the shares directly, and you don’t see it falling too much either because if you do, you might not want to own the stock at all.

“It’s not a bad trade, especially for those who have this range-bound view on the underlying security.”

For some, Delta Air Lines benefits from falling jet fuel costs as oil is hitting record lows.

Another oil trade

Equity analysts have been bullish on airlines stocks partly for that reason, sources said.

In a stock research report published Nov. 1, Jim Corridore, an analyst at S&P Capital IQ who has a “strong buy” rating, said that Delta benefits from lower oil prices and should continue to profit from the trend. He expects fuel costs to decline by 8% to 10% in 2014 after a 7% decline in 2013, which is one of the bullish factors in his analysis.

“This note can be viewed as a play on oil,” the market participant said.

“We’ve seen a few deals on that theme. Airlines are an example. Some companies in some sectors are expected to benefit from low oil prices as well ... retail for instance. When oil is cheap, the cost of shipping and distribution drops too.”

Structure

The structure offers some similarities with a reverse convertible but only in appearance, he said.

“You have the fixed coupon that can be used as a cushion if the stock price declines. So it looks a little bit like a traditional reverse convertible, but it’s different because it doesn’t offer the typical barrier,” he said.

A structurer said that this type of structure is not new.

“It’s a fairly standard digital note. You’re getting a coupon above a certain level in addition to the fixed coupon if the stock reaches a certain step. It pays a specific coupon and a second one depending on where the underlying is. You buy one digital at-the-money at 100 and one digital out-of-the-money at 110,” he said.

Derivatives alternative

An industry source said that other securities or strategies may permit investors to express a bullish view on the stock in a less expensive way

“If you believe that lower oil prices are going to be good for the airlines, on the surface that’s not a bad point of view to have. But why are you capping yourself at 16%? You have to be bullish for this investment. You just can’t enter the trade if you’re bearish,” he said.

The 16% “cap” is the sum of the 10% coupon and the 6% step payment, if any.

For this source, the coupon should not be considered as a form of downside protection.

“The 10% coupon is not a protection. If the stock is down, you’re turning the yield into a buffer. But you’re giving up your yield. More efficient alternatives can be found in the options market. You could buy a series of at-the-money calls on the stock or sell at-the-money puts and collect that premium,” he said.

BofA Merrill Lynch is the underwriter.

The fee is 1.75%.

The Cusip number is 06053M575.

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