Bank of America links STEP notes to JPMorgan; variation on reverse convertible, adviser says

By Kenneth Lim

Boston, July 30 - Bank of America Corp.'s planned STEP Income Securities linked to JPMorgan Chase & Co. could be an interesting play for investors who have a flattish outlook on the stock, an investment adviser said.

Bank of America plans to price 10% STEP Income Securities due September 2010 linked to the common stock of JPMorgan Chase & Co. Interest will be paid quarterly.

At maturity, if JPMorgan stock is at least 110% of its starting value, investors will receive par plus a step payment of 3% to 7% of the principal. The exact step payment will be set at pricing.

If JPMorgan shares finish below the step level but at or above the threshold level - 95% of the initial share price - the payout will be par. Investors will lose 1% for every 1% that the final share price is below the threshold level.

Merrill Lynch is the agent for the offering.

High interest, high risk

The product could attract income-seeking investors to the generous 10% coupon, the adviser said.

"Investors who are looking for income can easily do worse than 10% in today's market," the adviser said.

But the coupon also comes with significant risk, the adviser added. The stock of JPMorgan has a historical one-year volatility of about 100%, which suggests that there is a significant chance of the stock falling beyond the 5% buffer protection on the downside.

"It's very little protection considering the volatility of the stock," the adviser said. "You could buy a reverse convertible, which also gives you a stream of income, and you'll probably get better protection than 5%. The reverse convertible has a barrier, which is different from a buffer so we might not be comparing the same thing, but I think you'll find that at 5% it's most likely still poorer protection than a 30% barrier. Just taking into account the volatility of the stock."

Tight range

But the high underlying volatility also has implications on the upside. The ideal scenario for investors is if the stock ends between its starting value and 113% to 117% of the starting value, depending on where the product prices, the adviser said. Above that, investors will underperform the stock.

"So on the upside you're saying you don't think that JPM is going to end up above 113% to 117%, and on the downside you don't think it's going to be below 95%," the adviser said. "That's a very small range for a stock that's so volatile."

Going a step further, the adviser pointed out that investors only benefit from the step payment if the underlying stock falls within a small band.

"It's such a specific set of conditions in order to enjoy this extra payment," the adviser said. "You have to think if it's worth paying for it. If you don't think the product's going to go above 10%, you can look for better downside protection and skip the step-up."

The product could be seen as a variation of a reverse convertible, the adviser said.

"It's like a reverse convertible, but you take some of the barrier on the downside and you move it to the upside," the adviser said. "So instead of having that protection against a 3% to 7% drop in the stock, I have protection against a 3% to 7% underperformance if the stock goes above the coupon."

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