BofA Finance’s snowball on sector index basket offers attractive yield but no protection

By Emma Trincal

New York, July 20 – BofA Finance LLC’s Strategic Accelerated Redemption Securities due August 2022 linked to an equally weighted basket of three sector indexes pay an attractive annualized return upon early redemption, but advisers are reluctant to invest in a note lacking any downside protection.

The basket consists of the Financials Select Sector index, the Energy Select Sector index and the Health Care Select Sector index, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at a premium of 11% to 12% per year if the closing level of the basket is greater than its starting value on any observation date, six, nine, and 12 months after the pricing date.

Previously unpaid call premium will also be paid. The exact call premium will be set at pricing.

If the notes are not called, the payout at maturity will be par of $10 plus the return of the basket with full exposure to the decline.

Diversification

Michael Kalscheur, financial adviser with Castle Wealth Advisors, said the notes offered an attractive return for investors who have a sideways view on the market. Despite the absence of any downside protection, some elements in the structure were worth considering.

“It’s not a worst-of, which is a good thing. Plus, they picked three very different sectors, according to Morningstar. That gives you some diversification,” he said.

The financial sector, according to Morningstar methodology, belongs to the cyclical sector; health care is categorized as “defensive” and energy is part of the so-called “sensitive” sector, which responds directly and positively to economic growth.

Creditworthiness

Another plus was the issuer’s credit.

“I have no issue with Bank of America’s creditworthiness. They have pretty good CDS spreads,” he said.

BofA’s five-year credit-default swap spreads are 48 basis points, in line with those of Wells Fargo, according to Markit. JPMorgan shows the tightest spreads at 46 bps. The banks with the widest CDS spreads are Citigroup, Morgan Stanley and Goldman Sachs at 53 bps, 54 bps and 57 bps, respectively.

Upside

“You’re taking a bet on a six-month time period. If the basket is up, you get called with your premium at an annualized return of 11% to 12%,” he said.

“We like the call premium. If you invest in equity, you should be able to get at least 10%. Here it’s 11% to 12% annualized. From that standpoint, it checks the box.

“We also like the autocall. You get a few bites. If it’s called, you get paid.”

Risk

But the notes also had some downsides.

“The fee is kind of high. We’re not a fan of fees that are that high,” he said.

The full downside exposure was his most significant objection.

“It’s an issue for us, because we prefer having some protection. I can understand though that you can’t expect too much on a one-year,” he said.

This is what leads this adviser to extend maturities on the structured notes he buys for his investors.

The snowball payout, which offers a cumulative premium upon the call, helped mitigate some of the risk.

“We like the snowball,” he said.

If the structure was that of a Phoenix autocall in which investors receive a contingent coupon only when the conditions are met on the specific observation date without cumulative benefits, the note would have been of little interest to this adviser.

“We like the snowballs better. You want to be able to capture payments you have missed earlier.”

Still the three autocallable observations with their cumulative advantage did not replace the benefits of a downside protection whether delivered via a buffer or a barrier, he said.

“I’m looking for certain things in a structured note and the protection is one of them. In fact, it’s a priority for us.”

Mildly bullish play

Some investors may find the notes attractive based on their market outlook, he noted.

“If you don’t expect too much from the market, it offers a decent return. After all, the only way you can benefit from this note is if the market is flat,” he said.

“You lose if the market is down and if it’s up more than 12%, you lose as well.

“You really have to believe that the market is going to tread water for the next six to 12 months.”

In conclusion, Kalscheur said he would not be inclined to purchase the notes.

“It’s not the most exciting deal,” he said.

“But it’s not a bad offering and it checks some of the boxes, mostly on the upside.

“The fee and the no protection would be our main objections.”

Cost, risk-return

Steven Foldes, vice-chairman of Evensky & Katz / Foldes Financial Wealth Management, also pointed to the fee as a negative.

“I don’t love the note. The fee is pretty steep, particularly if you’re called after six months,” he said.

“I’m fine with BofA’s creditworthiness, but I have a problem with the note itself.

“Not only is the fee high but we’re at the top of the market.”

The basket could be negative in a year, he noted.

“Although 11% to 12% seems nice, you’re capping the return out while taking on all the risk,” he said.

Dividends

Noteholders do not receive dividend payments.

On a one-year term, the opportunity cost is lower than with longer-dated notes. However, some of the basket components pay higher dividends than average, such as the Energy Select Sector index, which yields 4.45%. The Financial Select index has a 1.73% yield and the Health Care Select yields 1.57%. Each component has a higher yield than the overall market with the S&P 500 index yielding 1.39%.

“You’re giving up a handsome dividend yield. The average yield in this basket is 2.5% plus 1.25% in fee.”

Taxes

Foldes also considered some of the tax characteristics.

The prospectus said that the “tax consequences of the notes are uncertain,” inviting investors to consult a tax adviser, as it is always the case with structured notes’ filings.

But the prospectus conveyed that in the case of an early redemption, investors may be subject to short-term capital gains.

“If the notes are called away, it’s unclear if you get hit with short-term capital gains or ordinary income,” he said.

“But in both cases, the tax treatment isn’t the most attractive.

“You pay upfront 1.25% in fee, there’s no downside protection, your upside is capped, you lose significant dividends, and you may not have any tax benefit from it.

“This would not be something I would show my clients.”

The notes are guaranteed by Bank of America Corp.

BofA Securities, Inc. is the agent.

The notes will price in July and settle in August.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.