Bank of America’s relative Stars on three stocks vs. T-bond fund offer bet on higher rates

By Emma Trincal

New York, Sept. 2 – Bank of America Corp.’s 0% relative value Strategic Accelerated Redemption Securities due September 2015 linked to the performance of a basket of three equally weighted financial stocks versus the iShares Barclays 20+ Year Treasury Bond fund enable investors to express a bearish view on Treasuries along with the expectation that financial stocks will outperform bonds, sources said.

The underlying companies are Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co., according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par of $10 plus a premium of 9% to 13% per year if the stock basket performs at or above the level of the T-bond fund on any of the three observation dates.

If the notes are not called, the payout at maturity will be par unless the basket finishes below the T-bond fund, in which case investors are exposed to the relative decline.

Investors in the notes expect the basket to outperform the T-bond fund, which is listed on the NYSE Arca under the symbol “TLT,” according to the prospectus. They expect to see their notes called as early as three months after inception. If the notes are not called because the bond fund has performed better than the basket on each call date, investors will lose money.

Moving parts

“There are a lot of moving parts,” said Tom Balcom, founder of 1650 Wealth Management. “It’s a play on Treasuries, but you also have to have a view on these three banking stocks – obviously you need a view on the financial sector as a whole. So you have more and more moving parts. It’s a complicated trade, that’s my biggest issue with this note.

“The whole premise is to get 13%, that’s what you try to gain, and that’s your best-case scenario. If the three stocks are higher than the TLT, that’s your reward.

“You’re short Treasuries and long the three financial stocks.”

Balcom said those two propositions were logically juxtaposed.

“If you believe that rates will go higher, it does make sense to expect that financial institutions will do better in this case because their profitability should increase in a rising rate environment,” he said.

“But meanwhile, you’re giving up on two high-yielding stocks out of three in this basket.”

JPMorgan pays a 2.8% annual dividend yield. Wells Fargo has a 2.7% yield, and Citigroup pays only 0.1%. The average yield for the basket is about 1.85%.

“You’re giving up almost 2%, which is not small,” he said.

From bull to bear

Investors in the notes would have to be nearly contrarian because they are betting on a relative value between the bond fund and the basket going in the opposite way as what the value is now, he noted.

“Right now, TLT significantly outperforms the basket,” he said.

Indeed, the year has seen a strong Treasury rally with TLT up nearly 15% this year to date, or almost twice the performance of the S&P 500 index, which has gained 8% this year.

Individually, the basket components have shown the following returns: a 0.25% loss for Citigroup, a 2% gain for JPMorgan and a 13.5% positive return for Wells Fargo. The basket performance averages 5%, which is 10 percentage points below the TLT return, he noted.

“Treasuries have rallied a lot this year as rates have come down. With things happening in Russia, Ukraine and in the Middle East, people are looking for safety in what appears to be a flight to quality,” he said.

While it may be justified to bet on a reverse trend and expect rates to go up, Balcom said that the timing of the reversal is very difficult to predict.

“Most people think interest rates will rise, but the question is, when is it going to happen? If rates go up, it would hurt the price of Treasuries and benefit financial companies. In this scenario, the deal makes sense. But this is a one-year trade, and no one knows when rates will go up and by how much,” he said.

Timing

Donald McCoy, financial adviser at Planners Financial Services, agreed that timing interest rates moves is nearly impossible.

He also noted the lack of any downside protection feature, making the notes risky, especially for a payout limited to the premium.

“In terms of probabilities, if you do get called, it’s likely that it will happen after three months and not later,” McCoy said.

“So if TLT loses 5% and the basket loses 3%, you get called at 2.5% assuming the premium is 10%.

“I understand the process of this deal and how it works. You might expect rising rates to be somewhat good for banks as they would earn higher spreads, so that part makes sense.

“But the timing is very tricky. Honestly, I have no idea who this trade would be for.

“Rates are not necessarily going to go up within a year. And timing the rise in interest rates is very unpredictable. It’s as if you were trying to predict what the Fed is going to do.”

Risky trade

McCoy emphasized the risk associated with the product in the absence of a call.

“Your best-case scenario would be not getting called until the end, which means that the stocks would underperform the entire time. But then you want the opposite. And that’s when it becomes very uncertain. The relative value is not likely to be positive on the last call date if it has not been on the other calls, so chances are the TLT would continue to outperform and you would lose principal,” he said.

McCoy said he always looks at the worst-case scenario.

He offered the following example: Rates do not come down, and Treasuries continue to rally. The bond fund finishes up 20% while the basket declines by 20%. In this example, investors would lose 40%.

“This structure offers no protection on the downside,” he said.

“Worst-case scenario, you have a market meltdown, people run to safety, Treasuries shoot up, bank stocks collapse.

“This is not for somebody who is worried about a market meltdown. It’s for someone who is fairly sure that equities will outperform Treasuries in the short term, someone who expects to be called on the first observation period.

“But anything can happen in three months. You’re just rolling the dice at this time. If your goal is a three-month trade, you agree to limit your profit to 2.5%. It’s basically like saying, ‘whatever. I’ve got a 60% chance of making 2.5% at the end of the three months, and then I’ll find something else to do with my money.’

“It’s certainly not a long-term investment, and you have to be willing to roll that trade after you get called and start all over again.”

© 2015 Prospect News.
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