Bank of America's step-up notes linked to DAX offer boosted return for small index gains

By Emma Trincal

New York, Jan. 31 - Bank of America Corp.'s 0% market-linked step-up notes due February 2013 linked to the DAX Price Return index offer investors a contingent minimum return that can exceed the final performance of the index without limiting the upside, sources said.

"You can make more than the index, and you're not capped," a market participant said. "This is why it's a good deal."

If the index finishes above the step-up value - 113% to 119% of the initial level - the payout at maturity will be par of $10 plus the index return, according to an FWP filing with the Securities and Exchange Commission.

The benefit of the structure kicks in when the index finishes at or above the initial level but below the step-up value: in that range, the payout at maturity will be par of $10 plus the step-up payment of 13% to 19%. By definition, this return exceeds the return of the index.

On the downside, investors will be exposed to any decline in the index.

The exact deal terms will be set at pricing.

Nice bump up

"You get a pretty decent guaranteed rate of return even if the index doesn't make it to the step-up level," a trader said. "It's really a good thing because there's no guarantee that German stocks over the next two years will be able to reach a 16% rate of return."

He derived the 16% rate from the midpoint of the 13% to 19% range.

"So even if your index ends up at plus 10%, you get 16%. It's a nice bump up.

"The beauty of it is that you're not capped. If the index has a 25% performance, you'll get that. It's a pure bet on the upside."

Downside risk

The trader did not read too much into the existence of downside risk.

One possible problem, he said, is the fact that the index has already appreciated over the past two years.

"German stocks have done pretty well as Germany has come out of the recession remarkably well," he said.

The DAX index is up 80% from its low in March 2009, he noted.

However, the index has yet to reach its past high of 2007, he said, adding that the current value of the index would have to go up by 28% to hit that level.

"I definitely think the DAX can go up by 10% to 15% in two years. But there's no guarantee for that, and if I'm wrong, if the index is up but not up that much, I still get the step-up guarantee," he said.

If the final performance is negative, investors in the notes are exposed to the same risk as those who are long the index, he said.

"These notes are designed for bulls only. Your risk is the same as an equity investor," he said. "And your upside is potentially greater."

Eric Greschner, portfolio manager at Regatta Research & Money Management, said that he was bullish on German stocks.

"We like German exporters," he said.

"As the world's economies stabilize and expand, Germany's exporters will see strong demand for their products continue into the foreseeable future."

In addition, Greschner said, German stocks should continue to rally due to this country's ability to keep its inflation rate low.

But he added that he did not like the fact that the structure failed to give investors any form of downside protection.

"I am leery about a two-year lock-up with no principal protection in the event problems with the peripheral countries flare up in a significant fashion," he said.

"I would prefer conditional downside protection vis-a-vis a barrier or a direct investment in the underlying asset where you have the ability to place stops."

No cap

The market participant said that one of the positive aspects of the notes was the combination of a bump-up payment for small or even no index gains and uncapped returns for larger gains.

"I like the fact that you have a little boost with a 0% return," he said.

"If you're mildly bullish, it gives you a nice return, but you're not giving up anything on the upside.

"If I wanted exposure to German stocks, that would be a way to do it."

The market participant, however, said that investors should take two things into consideration.

The first one, he said, was that the investment was a pure equity bet and not a currency play.

"This is a point-to-point investment in a stock index. The currency effect is stripped. So there is no gain or loss to make from any currency conversion. It's currency neutral," he said.

The second consideration was exposure to credit risk.

"You have to be comfortable with Bank of America," he said.

The DAX index measures the composite price performance of 30 selected German stocks that trade on the Frankfurt Stock Exchange.

The notes are expected to price in February and settle in March.

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

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