Bank of America's 0% Mitts tied to three indexes offers global stock exposure with low risk

By Emma Trincal

New York, April 23 - Bank of America Corp.'s planned 0% Market Index Target-Term Securities due April 2015 linked to the Dow Jones Euro Stoxx 50, Nikkei 225 and S&P 500 indexes may appeal to investors looking for some exposure to the global equity markets but with minimized risk, said Suzi Hampson, structured products analyst at Future Value Consultants.

The underlying indexes are equally weighted in the basket, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10.00 plus any basket gain, up to a maximum of $16.00 to $17.00 per note. The exact cap will be set at pricing.

Investors will receive at least par.

Price of protection

Hampson said that the five-year product is a principal-protected instrument and hence it offers a different risk/return profile than most other structured products.

"It is definitely designed for risk-adverse investors," she said. "Yet, investors need to keep in mind that they remain subject to the credit risk of Bank of America."

In this product, investors pay for their protection by limiting their return to a cap, she said, to be set between 60% and 70%.

The structuring of a principal-protected note requires combining a zero-coupon bond that will mature at par with the purchase of a call option, said Hampson.

"The difference between the notional and the cost of the zero is what's left for the option," said Hampson. "The lower the cost of the option, the better the terms the bank may be able to offer."

Several factors affect the cost of the option, such as duration. In this case, the five-year maturity allows the issuer to raise the cap to an attractive level, she said.

But the key factor is volatility when it comes to option pricing, she said. "For a simple call option, when volatility rises so does the cost of the option," she said.

Growth too

Hampson noted that the product was attractive for growth as well, within the principal-protected category.

She assumed that the issuer would set the cap at the mid-point of the range, 65%, at pricing.

A 65% cap for five years would be the equivalent of an approximately 10.5% per annum compounded rate, said Hampson.

"Considering that this is a principal-protected product and therefore as far as risk/return goes, that it should be compared with cash, the product appears to offer an attractive rate of return," she said.

She took the five-year Treasury yielding 2.5% as an approximate benchmark for a risk-free asset.

"If we add, for instance, a 2% spread over Treasuries to reflect the credit risk, or what the funding figures are - and this is just an example - you would have 2.5% plus 2%, or less than 5% as an approximate point of comparison," said Hampson. "The maximum of 10.5% per annum investors receive with this product looks good to me and shouldn't be much of an off-putting feature for the cautious investor," she said.

Low risk score

Riskmap - a Future Value Consultants rating that measures the risk associated with a product on a scale from zero to 10 - was 1.60 for this product. The notes have a low riskmap rating as a result of the principal return feature.

"The structure of the product is the reason why the riskmap is so low," Hampson said.

Investors continue to be subject to credit risk though, and Hampson said that the credit of Bank of America was not among the best compared to its peers as measured by credit default swap spreads.

"Credit default swap spreads of Bank of America are approximately 140 basis points, which is reasonably high considering the levels of other issuers in the market right now. I would have actually expected the riskmap to be a little higher than that considering the issuer," she said.

Odds of returns

Future Value Consultants uses a Monte Carlo simulation model to measure the return probabilities outcomes.

The firm presents these probabilities by return buckets in a table published in its reports.

The performance is modeled based on a series of parameters, which include volatility, dividends and interest rates among others, said Hampson.

With this deal, the probability of losing principal is zero given the protection embedded in the structure. On the other hand, probabilities vary by buckets on the upside.

One interesting result, she said, is that the odds of generating a 10% to 15% return per year is greater than the probability of earning a lesser gain comprised between 5% and 10% per year.

The probabilities are 51.6% and 14.3%, respectively.

"This is saying that there is a high chance of hitting the cap, or getting very close to it," said Hampson. "We assume a fairly high growth percentage for equities, so for this product this uplift makes the chance of very decent returns more likely."

On the other hand, Hampson explained why the likelihood of earning 0% to 5% are greater - with a 34.1% probability - than the 14.3% chance of getting a return situated in the 5% to 10% bucket.

"The 0% to 5% return bucket includes the possibility of the basket going down. In the case of this product, if the final level of the basket is lower than its initial the investor receives 100% of capital, which falls in this category," Hampson explained.

High return score

Given the low level of risk, narrowed down to credit risk, and the positive return outcome as measured by these probabilities, the product's return rating was 7.05.

Return rating is Future Value Consultants' indicator, on a scale of zero to 10, of the risk-adjusted return of the notes.

"This product performs very well on the return rating scale. Most products get between 3 and 5 for return, so a 7 is very good," Hampson said.

A good return rating combined with a high value rating and a high simplicity rating enhances the overall rating of a product. The overall rating on a scale of zero to 10 is Future Value Consultants' opinion of a deal. It is an average of the three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity.

The value rating of these notes was high at 9.49. This rating measures on the same scale how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

"Value looks good compared to other deals," said Hampson.

The simplicity rating, which is Future Value Consultants' opinion on a scale of zero to 10 of the simplicity of a structure, is again high for this transaction, scoring 9.

Those three scores gave a high overall rating of 8.42.

Global exposure

Speaking on the possible market view reflected by the underlying of this product, Hampson said, "The basket is not a new combination; it's a very common basket. But it's a good global equity measure. It's diversified as it certainly covers three major equity markets."

"However, if the investor has a lot of U.S. equity, they might want to get something else given the 33% allocation to the S&P 500," she added.

The notes will price in April and settle in May.

Merrill Lynch, Pierce, Fenner & Smith Inc. and First Republic Securities Co., LLC are the agents.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.