Bank of America plans notes with five times leverage tied to Euro Stoxx 50 aimed at mild bulls

By Emma Trincal

New York, Jan. 30 – Bank of America Corp.’s 0% notes due January 2019 linked to the Euro Stoxx 50 index give investors an opportunity to outperform the index under a moderately bullish market scenario, said Tim Vile, structured products analyst at Future Value Consultants.

If the index return is positive, the payout at maturity will be par of $10 plus five times the index return, subject to a maximum return of 70% to 74% that will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is negative, investors will be fully exposed to the decline.

In its research reports, Future Value Consultants assesses risk, return and price using a variety of proprietary scores in order to compare a product with others. The research firm compares each product to two different averages: same product type and all recently issued notes across all structure types.

The Bank of America notes fit into the “leveraged return” category in Future Value Consultants’ methodology, which is defined by products having an upside participation rate above 100%.

Since the cap is set in a 70% to 74% range, Vile chose the 72% midpoint as the hypothetical cap for the ratings.

This cap on a four-year maturity with a five times leverage factor will give investors a 14.52% annualized cap on a compounded basis.

“To achieve this cap the underlying index doesn’t have to increase by a lot,” he said.

An appreciation of the index price of 14.40% over the four-year term, which represents 3.42% per year with compounding, will be enough to bring investors to the maximum return level.

“It’s not bad at all. If the index is up 2% a year, you still get 10% a year. That’s a pretty good return,” he said.

Moderately bullish

“The notes target a quite bullish investor to the extent that he doesn’t expect the index to drop at all. If he did, he would want some form of downside protection, which doesn’t exist here,” he said.

“On the other hand, the buyer of these notes can’t be too bullish in terms of optimization of the return. You have to have very moderate growth expectations knowing that if the index is up by more than 3.5%, you’ll be capped out and miss on a higher return. However, the cap is not bad at all. It still offers a very good return.”

On the downside, the lack of any protection means that investors are willing to risk a loss of principal and therefore should have a high tolerance for risk.

“You’re unlikely to get a barrier or a buffer when you have five times the index return with a cap of 14.5%. It’s only with less gearing or with a lower cap that the issuer would have been able to include a downside protection feature,” he said.

“The investor is not overly bullish for taking the cap. But he is bullish enough to accept to be subject to the full downside exposure.”

Higher risk

Future Value Consultants assesses the risk associated with a product by adding two risk components: market risk and credit risk. The resulting riskmap measures risk on a scale of zero to 10 with 10 as the highest level of risk possible.

The notes, which are compared to other leveraged products that may in many cases offer barriers or buffers, show a higher level of market risk, according to the market riskmap of the report.

The average market riskmap is 3 for all products and less than 3 for the same product type. But the notes have a market riskmap of 4.88, which is much higher, he said.

“Part of the reason is the volatility of the Euro Stoxx. You compare this note with many leveraged notes that are tied to the S&P 500. There is more volatility in the European equity benchmark,” he said.

The implied volatility of the Euro Stoxx 50 is about 21% versus 16% for the S&P 500 index.

“But the main factor of course is the absence of any downside protection,” he said.

The credit risk of the notes is also higher than average, the report showed, with a credit riskmap of 0.67, compared with an average of 0.54 for leveraged notes.

“This is due to the length of the notes – four-year is longer than average – and also to the credit default swap rates of the issuer, which are a bit wider than other banks,” he said.

As a result, the riskmap is 5.55, which is “very high” compared to the market, he noted.

The average riskmap is 3.48 for all products and 3.43 for leveraged notes.

Risk-adjusted return

“On the other hand, the return score, which measures the risk-adjusted return, is very competitive,” he said.

The notes showed an 8.36 return score versus an average of 7.69 for the same product type and 7.42 for all products.

The return score is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. The best of the five scenarios is selected to measure the risk-adjusted return on a scale of zero to 10. With this product, the optimal scenario is bullish.

“When you take a longer duration – four-year here – [and] five times gearing, you have in a bullish scenario a decent chance to maximize your upside. While the notes are capped, you’re getting almost 15% a year, which is above average for capped leveraged products. The combination of a high gearing, high cap and enough time to cumulate returns makes this product very attractive from a risk-reward standpoint despite its riskiness. You are incurring risk, but you are getting fairly compensated for it,” he said.

Price, overall scores

In comparison, the price score is “disappointing,” he said, at 6.09 versus an average of 7.33 for the same product type.

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. 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 length of the product is not a factor behind the low rating, he said, adding that the price score tends to actually improve with longer maturities since fees are calculated on an annualized basis.

“Perhaps one explanation is the credit risk, which is slightly higher. The wider CDS spreads may bring down the price score because the funding rate doesn’t give the issuer enough money to buy the call options, hence making the economics of the deal less attractive,” he said.

“An even higher cap would have contributed to improve the price score. A barrier or buffer would have been an option as well.”

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The notes showed a 7.22 overall score, close to the average for the same product type of 7.51.

“It comes out average. Investors can find a return that stands out. But they have to be willing to take the risk for it,” he said.

The notes will settle in February.

BofA Merrill Lynch is the agent.

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