Bank of America's protected Mitts tied to Dow Industrials offer attractive risk/return profile

By Emma Trincal

New York, Jan. 7 - Bank of America Corp.'s 0% Market Index Target-Term Securities due January 2016 linked to the Dow Jones Industrial Average offer an attractive risk/reward profile for risk-adverse investors, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par of $10.00 plus any index gain, up to a maximum of $15.50 to $16.50 per note, according to an FWP filing with the Securities and Exchange Commission.

The exact cap will be set at pricing.

If the index falls, the payout will be par.

Risk aversion

"This is for the risk-adverse investor looking for an investment in U.S. equities," she said.

"This deal has a relatively low risk profile with a good return score, which makes it attractive."

Riskmap - a Future Value Consultants rating that measures the risk associated with a product on a scale of zero to 10 - is on the low end of the spectrum at 1.98, said Hampson. The indicator is situated on the left side of the chart, suggesting that the notes represent a far lower risk than other products in a variety of structures.

"This is principal-protected, so obviously it's low risk. The 1.98 rating is all credit risk," she said.

But even that level of risk remained low because Bank of America's creditworthiness is above average, she said.

"They have a fairly substantial credit default swap level of 180 basis points, which is quite good compared to other banks," she noted.

Other risks involved with structured notes, such as limited liquidity on the secondary market, are not accounted for in the riskmap, she explained. "It's understood that all structured products involve this type of risk," she said.

Cap, return outcome

Future Value Consultants publishes a chart that displays probabilities of returns across different return buckets. According to this chart, which is based on a Monte Carlo simulation model, investors have a 16.3% chance of earning an annual return of 5% to 10%. The odds of making a 10% to 10.5% gain per year are 16.7%.

The 55% to 65% cap for a five-year term is the equivalent of 10% to 10.5% per year with the compounding factor.

"There is a greater probability on the highest bucket, which simply shows that there is a high probability of hitting the cap," said Hampson.

"The issuer would not be able to offer the principal protection if they didn't have the cap, or they would have had to change the terms," she said.

Duration

One way an issuer could offer a principal-protected note based on the Dow Jones but without a cap would be to extend the maturity to six years from five, she said.

She offered two examples among recently announced deals: Goldman Sachs Group, Inc.'s six-year 0% equity index-linked notes tied to the Dow Jones Industrial Average and Morgan Stanley's 0% equity-linked notes due Jan. 27, 2017 tied to the same benchmark. Neither of those products featured a cap.

Even if five years is shorter than six, it is still a long-term investment, said Hampson.

"Buyers of this product would have to be prepared to invest in a five-year instrument, which may not suit all investors," she said.

Capping returns or extending durations are often the only resources left for issuers trying to put together principal-protected products in a low-interest-rates environment, she said.

Structuring a principal-protected product requires combining a zero-coupon bond that will mature at par with the purchase of a call option. With low interest rates, the cost of zero-coupon bonds increase, which leaves little room to buy the option, she said.

"We don't see that many principal-protected products in the U.S. At the moment, rates are low, which makes pricing difficult. That's one reason," Hampson said.

"Also, I think historically, U.S. structured products investors seem to go for the 'at-risk' products like the reverse convertibles or accelerated growth notes."

The choice of the underlying may also give structurers some leeway. By picking a less-volatile underlying index, the issuer reduces the cost of the option. It is the case with these notes, tied to the Dow Jones Industrial Average, which shows a 19% implied volatility. In contrast, the S&P 500 index has an annual implied volatility of around 21%.

"The options are slightly cheaper [than for the S&P 500] and therefore, the issuers can offer more attractive terms," she said.

Return score

The odds for investors of making a 0% to 5% profit per year are two-thirds, while there is a one-third chance of coming up with a gain of 5% to 10.5%. The probability of losing money is none since the model only takes into account market risk for the calculation of the return outcomes and excludes other factors such as credit risk.

These probabilities are reflected in an above-average return rating of 5, according to Hampson.

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

"It's a good return score. Although 5 doesn't sound great, it is good compared to the 3.5 average," she said.

Since the product is easy to explain and understand, its simplicity rating, on a scale of zero to 10, scores high at 9.

Value

The value score, which represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis, is also elevated at 9.59. This rating scores products across all structures. Since a long duration can increase value, principal-protected notes tend to score high on the value scale, according to Hampson.

"The value score is pretty good. We look at value on an annualized basis. Sometimes, the longer the term of the product, the better the value rating is. That's because any fixed cost is spread out over the five years, which in itself increases the value," she said.

The overall rating - Future Value Consultants' opinion on the quality of a deal taking into account costs, structure and risk/return profile on a scale of zero to 10 - is 7.63. It's an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

"The low risk score and the high return rating make this a valuable product for conservative investors," said Hampson.

The notes are expected to price this month.

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

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