Bank of America's $48.83 million Mitts on Dow Jones Industrials seen as attractive, yet pricy

By Emma Trincal

New York, March 2 - A $48.83 million leveraged note from Bank of America Corp. offering 90% principal protection was seen as attractive for offering significant protection on the downside with a leveraged and uncapped return on the upside.

But some said that the structure may not be cost-efficient enough for investors given the fee and other aspects.

Bank of America priced 0% Market Index Target-Term Securities due Feb. 26, 2016 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 122% of any index gain. Investors will be exposed to any index decline, subject to a minimum payout of $9 per security.

Attractive structure

"The market shows growing appetite for risk, but there's always demand for principal-protected products. This one is obviously for the conservative investor," a market participant said.

"The five-year term is not particularly short. Most principal-protected products have a four- to-five-year tenor.

"What's attractive here is that you have leverage and you don't have a cap. You get that by having 90% of your principal protected instead of full protection. In addition, your upside is leveraged while your downside is not."

A hedge

A sellsider said the product could be used as a hedge for investors long the index.

"This could be for someone who thinks that the Dow Jones Industrial can still go up but might have some pullback," this sellsider said. "They don't want to sell their position, but they don't want to put a lot more money into it."

Do-it-yourself

Larry Swedroe, principal and director of research at the Buckingham Family of Financial Services, said, "This doesn't look like such a terrible deal. You get 122% leverage, and you're only eating 10% of the downside risk."

But he added that there are ways for investors to accomplish the same trade at a lower cost.

"You can do it cheaper yourself. You could buy a five-year out-of-the-money put for your 90% protection and invest your money on the Dow Jones or even on a more diversified index and keep the dividends," he said.

Foregoing dividends, however, is not the most costly aspect of the structure, he said.

The roughly 1.5% dividend yield on the Dow Jones Industrial Average is "fairly low," he said. It helps, he added, as it lowers the implied cost of foregoing dividends.

"Still, dividends remain a significant portion of your total expected return, and you're giving up on that."

Cost

Swedroe broke down the cost of the notes to investors in three components.

The first one was the 2.5% fee.

Second, investors incur the implied cost of giving up dividends, which is five times 1.5%, or 7.5% for the five-year term. "And that's forgetting the compounding," he noted.

Finally, investors should factor in the cost of not being compensated for taking on the credit risk, he said. He measured it as the spread between the yield on a five-year corporate note issued by Bank of America and the five-year Treasury yield, which is currently 2%.

"Assuming that Bank of America's spread over Treasuries is 200 basis points, your implied cost for taking on the credit risk is 2% a year, or 10% for the term," he said.

Based on this, the total cost to investors is 20% over the five year period, he said. "And that's forgetting the compounding."

"Of course you can buy a put for a lot less than that. Granted, you don't get the 122% leverage. But you could replicate the leverage at a cheaper cost by buying a call. There are ways to accomplish leverage," he said.

Swedroe said that the "put should be very cheap" as "there has not been a single five-year period where the market dropped 10%."

In addition, the option is exercised at the end of the term, which is "much cheaper" than American-style options, which can be exercised at any time, he noted.

"People don't realize how cheap options are on the long term," he said.

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

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