Merrill Lynch links to health care, consumer staples; risky structure but stable underlying, analyst says

By Kenneth Lim

Boston, Nov. 7 - The underlying basket of health care and consumer staples indexes in a series of Merrill Lynch & Co., Inc. accelerated notes has an unusually low volatility, said structured products analyst Suzi Hampson of Future Value Consultants.

Merrill Lynch plans to price zero-coupon accelerated return notes due January 2010 linked to an equally weighted basket of the Health Care Select and Consumer Staples Select Sector indexes.

At maturity, investors will receive par plus triple any gain in the underlying basket, subject to a maximum total payout of 120% to 124% of the principal. The cap will be set at pricing.

Investors will lose 1% for every 1% decline in the basket.

Underlying stability

A couple of factors help the product to be less volatile than many other recent products offered with the same wrapper, Hampson said.

"One of the things to note is usually with a basket the volatility will decrease, so by using two funds it will decrease their volatility a bit," she said. "Also, looking at the volatility, they seem to have a lower volatility at the moment than the S&P 500 itself. It's quite unusual, actually."

The low volatility could also be due to the fact that consumer staples and health care tend to be more stable, Hampson said.

"Recently we've seen a lot linked to the finance sector," she said. "I don't know if they're more popular, but maybe they're offering some variation, something that's more stable like healthcare...Consumer staples and health care might appeal to people who though they were more stable, something less volatile than the finance sector."

Risky structure

The structure of the products, however, is quite risky, Hampson noted.

"As far as the terms go, it doesn't have a buffer, it's 1-for-1 on the downside, which obviously is going to make it reasonably high on the risk-map," she said.

In a research note, Future Value gave the product an overall rating of 8.35 out of a maximum of 10, placing the product among the higher rated ones among recent offerings. Its risk score for the product was 3.75 out of the riskiest score of 10, placing it near the midpoint of recent products.

"I think the high value score comes from these indices, because the volatility is fairly reasonable, when they're put together in a basket the volatility decreases, and therefore...when it models out it's fairly well rated," Hampson said.

She also noted that a series of performance leveraged upside securities due December 2009 linked to the S&P 500 index, offered by JPMorgan, had poorer scores than the Merrill Lynch product largely because of the different underlying. The S&P 500-linked noted had an overall rating of 5.91 and a risk score of 6.91.

"The products do have very similar terms, but the S&P one doesn't come out particularly well," Hampson said. "I would say it's because of the volatility."

Still risky overall

Hampson's conclusion was that the product was still targeted mostly at investors who had a fair amount of risk tolerance.

"Obviously it's still got a quite high risk-map and no downside protection, so you'd have to be comfortable with a fair amount of risk as an investor," she said.

But on a relative basis, the product would be less risky than many other recent products that have come in a similar structure, she added.

"A few months ago, a risk-map score of 3.75 would have been quite high, but now it's mid-range," she said.

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