Merrill offers bearish notes on S&P 500, real estate fund; products not prediction indicators, adviser says

By Kenneth Lim

Boston, Nov. 3 - Merrill Lynch & Co., Inc. opened its November calendar with a couple of leveraged bear notes linked to recently beaten down indexes, but the offerings are not necessarily an indication of the markets' outlooks, an investment adviser said.

Merrill Lynch plans to price zero-coupon accelerated return bear market notes due January 2010 linked to the S&P 500 index.

At maturity, the notes will pay five times any decline in the underlying index, subject to a maximum total payout of 120% to 124% of the principal. If the index finishes with a positive return but does not end higher than 110% of its initial level, investors will receive par. Investors will lose 1% for every 1% increase in the index if it ends above 110% of the initial level.

The exact return cap will be set at pricing.

The bank is also offering zero-coupon bear market strategic accelerated redemption securities due June 2010 linked to the iShares Dow Jones U.S. Real Estate Index Fund.

The securities will be called on any of three observation dates if the underlying fund is less than or equal to its starting value on those dates. The redemption amount - equivalent to a call premium of 13% to 17% per year - for each $10 par note will be $10.65 to $10.85 if called in June 2009, $11.30 to $11.70 if called in December 2009 and $11.95 to $12.55 if called in May 2010.

The exact call premium will be set at pricing.

If the notes are not called, investors will receive $10 per note if the fund does not finish at more than 110% of its initial level. Otherwise investors will lose 1% for every 1% increase in the fund.

High payouts, risks

The offer attractive payouts, but the risks are high, an investment adviser said.

"The one thing that jumps out [with the S&P-linked notes] is the five-times leverage factor," the adviser said. "As long as the index is down 5% after about two years you already reach the upper limit, which means you get about 22% after two years, which is a very good yield today. But it's also highly risky, because you get no principal protection, and the buffer is only 10%."

The adviser also noted that non-capital protected bearish products perform relatively worse than bullish products when investors turn out to have taken the wrong view.

"Here's the sort of simple way to understand it," the adviser said. "If I have a non-principal protected bull note and the underlying drops, let's say I have a 1-to-1 exposure on the downside, then I lose maybe 15% if the market is down 15%. But I still haven't underperformed the market, right? I'm the same as if I bought directly into the underlying. But a bear note, if it's the same 1-to-1 exposure and the underlying goes up by 15%, I don't just lose 15% on my principal, I also severely underperformed the underlying."

Notes not outlook indicators

The offerings by Merrill Lynch do not necessarily suggest that investors or the issuers are predicting further drops in the underlying indexes, the adviser said.

Many issuers are neutral on the outcome of the notes because they are hedged, and the notes are probably just a reflection of an increase in interest, the adviser said.

"I would think that because of what's going on there's definitely an increase in the percentage of the pie that's bearish right now," the adviser said.

"But that's not necessarily an indicator that that's where the market is heading. One year ago a lot of people were still thinking that the market would pick up this year. But one common mistake that a lot of people make, and I have to explain this all the time, is that you're not betting against the issuer. The issuers don't know more than you do about this."

Bullish products also continue to outnumber bearish products, the adviser said.

"I still see a lot of bull notes coming out," the adviser said. "Again, I wouldn't take that as an indication of investor sentiment. Bull products I think tend to be more popular because people are more familiar with them and because they're in general less risky, which is an important feature nowadays."

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