Bank of America’s 10% to 12% autocallables linked to Facebook show more risk than average

By Emma Trincal

New York, Nov. 20 – Bank of America Corp.’s autocallable coupon-bearing notes due December 2016 linked to Facebook, Inc. offer investors a high yield but more risk than average given the volatility of the stock and the unusual absence of any barrier, said Tim Vile, structured product analyst at Future Value Consultants.

The interest rate is expected to be 10% to 12% per year. Interest will be payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically called at par of $10 if Facebook stock closes at or above the call level, 100% of the initial share price, on either observation date, which will fall in May 2016 and August 2016.

If the notes are not called and the final share price is greater than or equal to the initial share price, the payout at maturity will be par. Otherwise, investors will be fully exposed to the stock’s decline.

“This note is a reverse convertible with its fixed coupon of 10% to 12%. It’s tied to Facebook, a pretty volatile stock with the capacity to move a lot up or down,” Vile said.

Since its initial public offering in May 2012, Facebook has surged 255% to $107 per share from its initial $30 price.

But over short periods of time, the stock can drop quite strongly, he noted. Last Monday for instance, the stock was down 8.5% from its level observed four trading sessions earlier.

No barrier

By selling the volatility, the issuer is able to provide a double-digit coupon over a one-year term, Vile explained.

“Another way for the issuer to enhance the yield was to eliminate the barrier,” he said.

“Usually reverse convertibles come with a barrier. The barrier may be hit anytime or at maturity. But there is a barrier most of the time. So the absence of a barrier increases risk.

“On the other hand, the fact that the notes are autocallable change the risk profile somewhat compared to a traditional reverse convertible with no automatic call feature.

“Autocalls tend to be less risky because once the notes are called – which is what investors are looking for – the risk is removed,” he said adding that investors at that point are guaranteed to get all of their money back absent a credit event.

Call protection

The schedule of observation dates is not exactly quarterly since there is no call date after three months, he noted.

“The first call date is after six months, then nine months. Skipping the first quarter adds a little bit more risk and is another way for the issuer to boost the coupon,” he said.

Future Value Consultants in its research assesses risk, return and price using a variety of proprietary scores in order to compare a product with others. Each score is compared to the average score for all products.

The firm calculates the market risk and the credit risk and adds the two components to generate the “riskmap,” which measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible.

Market risk

The notes have a 3.63 market riskmap versus an average of 3.28 for the average of all products, according to the research report generated by Future Value Consultants.

“The 12% coupon is a great yield, but it comes with substantial risk, which is reflected in the market riskmap,” he said.

The stock has an implied volatility “in the 30’s,” he said, compared with an implied volatility of about 15% for the S&P 500 index.

“It’s a high-volatility stock – not excessively high but fairly high,” he said.

“Combine the volatility with the lack of any downside protection ... your market risk is going to be significant.”

However, the notes ended up showing a market riskmap less elevated than expected.

“We have a few elements in the structure that help,” he said.

“First, the autocall, which offers a mitigated level of risk,” he said.

“Second, the notes pay a fixed coupon. Worst-case scenario, you lose your income but you can use the coupon as a buffer,” he said.

“Finally, it’s a shorter maturity, so in theory the stock may not fluctuate as much, although this one can show wide moves in a relatively short time.

“In general there is more risk over longer tenors, which is one of the reasons barriers tend to be lower over three- or five-year periods.

“The fact that we don’t have any barrier here reflects the difficulty to price protection over a short period of time.”

At 0.33, the credit riskmap was average compared to an average score of 0.36 for all products, according to the report.

“The short duration reduces credit risk exposure, which is good. When we calculate the credit riskmap, we estimate the duration going through different call scenarios in our model. We use the average and we annualize it. The autocall is going to lower the credit risk significantly.

“Bank of America’s credit is relatively average. The main factor here is the short term.”

Adding market and credit riskmaps together, the notes show a riskmap of 3.96, compared with a 3.64 average for all product types.

Low return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets, and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then computed. The return score is based on the best of the five scenarios, which in this case is bullish.

The return score is 5.83 versus the 8.23 average for all products, according to the report.

“Obviously, it’s not great. You have the riskmap factor, although the riskmap is not terribly high compared to the average. What’s more relevant is the capping of your return. The fixed coupon really restricts your upside. You can’t take advantage of the stock appreciation if it rallies,” he said.

Value

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes have a 5.75 price score, while the average is 6.50.

“This note offers less value to the investor than the average for all products,” he said.

“One of the issues is the one-year term. We calculate our fees on an annualized basis, so over the course of a year, investors don’t really have enough time to amortize the cost.

“The autocall makes it potentially worse. If the notes are called after six months, the fee paid upfront for a year would make this investment very expensive.

“Finally with the absence of any protection, you could lose everything. It doesn’t translate well in terms of pricing.”

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

For all products, the average overall score is 7.36. The notes in comparison have an overall of only 5.79.

“This final score suggests that the structure is a little bit disappointing,” he said.

“Those autocalls are designed to provide an above-market yield without taking on too much risk.

“With this product, you find bullish and non-bullish attributes. It’s hard to decide whether it’s bullish or not. It’s a little bit confusing.

“In some ways, the notes clearly are not designed for bulls. You have a fixed coupon. You don’t need to expect the stock to rally a lot to get paid. In fact, you do get your coupon even if the stock stays flat. You’re not looking to participate in a rally, Your return is income. It’s not linked to the performance of Facebook.

“At the same time, 12% is a pretty high return.

“And since there is no downside protection, you have to have the confidence of a bull to tolerate it.

“The risk-reward is a little bit puzzling, and it’s not clear really who would invest in the product.”

BofA Merrill Lynch is the agent.

The notes will price in November and settle in December.

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