Bank of America's step-up notes tied to S&P 500 offer unusually large buffer, longer duration

By Emma Trincal

New York, April 29 - Bank of America Corp.'s planned 0% market-linked step-up notes due May 2018 linked to the S&P 500 index drew attention for the size of their buffer, according to market sources.

If the final index level is greater than the step-up value, the payout at maturity will be par of $10 plus the index return. The step-up value is expected to be 117% to 123% of the initial index level, according to an FWP filing with the Securities and Exchange Commission.

If the final index level is greater than or equal to the initial level but less than or equal to the step-up value, the payout will be par plus the step-up payment, which is expected to be 17% to 23%.

If the index falls by up to 20%, the payout will be par. Investors will lose 1% for every 1% decline beyond the 20% buffer.

The exact terms will be set at pricing.

Each month, Bank of America prices market-linked step-up notes using the same structure, but sources said this one was different for the size of the downside protection it offered.

Typically, Bank of America sells shorter-dated step-up notes with little or no protection.

"This one has a longer duration with a pretty good buffer," a market source said.

Many of Bank of America's recently priced step-ups have a one- to three-year tenor with a coupon but no downside protection or one that is very limited in size, such as 5%, according to data compiled by Prospect News.

"A 20% buffer is not that common even on the five-year note. It's a viable product," the market participant said.

"It's not just that it's 20%. It's also a buffer, not a barrier. Usually for that level of protection, you're more likely to get a barrier instead."

"I kind of like it, frankly," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"It's straightforward; the issuer is not trying to be cute with complicated features. It's a fair buffer. There is no cap on the upside. You're fully exposed to the upside. And you're only losing money below the buffer level, not from the initial price. That makes a big difference," he said.

Other deals

The step-up notes Bank of America prices or sells on the behalf of another issuer are usually well received by the market. Recently, Bank of America sold Barclays Bank plc's $121.61 million of 8% STEP Income Securities due May 23, 2014 linked to Ford Motor Co. stock. The interest was payable quarterly. The step level was 108% of the initial price, and the step payment was 7.52%. If the stock finished negative, however, investors had no downside protection.

Other Bank of America market-linked step-up notes featured an autocall observable during the life, according to the data.

For instance, in late January, Bank of America priced $62.42 million 0% autocallable market-linked step-up notes due Jan. 25, 2016 linked to the Russell 2000 index.

The notes were automatically called with an increasing call premium if the index closed at or above the initial index level on either of two observation dates with 10% for the first call date and 20% for the second a year later.

At maturity, the step-up value was 30.07% for any index gain below the 130.07% step-up level. Above that level, investors received the uncapped index growth performance. The downside protection was limited to a 5% buffer.

Defensive

Looking at the structure of the notes, the market participant said that introducing a longer maturity with more protection changed the risk-return profile of the typical investor in these bullish notes.

"It's designed for a conservative investor, for someone who is afraid to lose on the downside. It's a conservative equity investment participation product for people who want to limit losses," he said.

"The trade-off is that you're giving up on the dividends over a five-year period. So even if there is no limit on the upside, no cap, you're still missing out on the 10% dividends that you'd get on the index."

Assuming that the step level was set at 120% and that the index finished with a 10% gain, he said that investors in the notes and investors in the equity index would get the same return.

"The notes would [give] you the 20% step payment. The index would give you 10% in price appreciation and 10% in dividends," he said.

The dividend yield on the S&P 500 is roughly 2%, which is 10% over a five-year period.

"So it's not like you're outperforming the benchmark with that return. You're foregoing dividends. Sure, it's true of all structured notes though. At least this one doesn't look like a rip-off," he added.

"And with the buffer, you can outperform on the downside by 20%.

"It's more of a conservative product because the chances of outperforming the market on the upside are more remote.

"The market would have to increase by less than 10% after five years for you to beat the index."

Investors considering this type of product as opposed to the usually shorter-dated notes offered with this kind of payout would have to pay attention to the consequences of a longer tenor, he said.

"Over five years, you incur more credit risk, obviously. You own Bank of America for five years, not one or two years," he said.

The relationship between duration and market risk was less obvious.

"It really depends. While some people feel safer about owning the notes for longer because they feel like if there's a crash the market may have enough time to rebound, it really depends on the timing of a market correction if you get one during that period. It's subjective," he said.

Bullish note

Kunhardt said that the notes offered a different trade-off than a direct equity investment.

"You can't really compare. With this, there's no dividend. But with equities, you don't have the buffer. It's not apples to apples," he said.

"With a structured note, you never have the dividend to begin with. You go for a structured note for a reason.

"Usually, it's because you want the same market exposure but with a different risk profile."

Kunhardt said that the longer maturity was not a real concern for him.

"There really are only two downsides with the five-year term," he said.

"First, the credit quality. Frankly, that's not much of an issue. Bank of America is too big to fail. The government has already proven that. They are not going to let it fail. With JPMorgan, Bank of America is one of the two eight-hundred-pound gorillas. Everybody else falls behind.

"Second, you're exposed to the market for a longer period of time. In terms of market risk, I don't think it's much of an issue either. Everybody expects the next five years are going to be a continuation of the secular bull. Most analysts, economists I talk to are bullish on the market. They've looked at the fundamentals and what they see is that everything is still undervalued. The average P/E is 15. It's not comparable to the crazy valuations we had during the dotcom bubble in 1999-2000. It's not an overheated market. It's still undervalued. It's still underpriced. The fundamentals are still improving."

For a bull, the notes offered a good instrument to capture more upside over the next five years, he said.

"You're not capped, which is great. You can make some pretty good returns if you have, as I do, a bullish outlook on the economy and on the market. At the same time, if you happen to be wrong, you've got this really attractive 20% buffer," he said.

The notes are expected to price in May and settle in June.

BofA Merrill Lynch is the agent.

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