BofA’s 42-month par-protected notes tied to FTSE 100 may mature too soon if market crashes

By Emma Trincal

New York, July 13 – BofA Finance LLC’s 0% leveraged notes due Jan. 28, 2022 linked to the FTSE 100 index could appeal to conservative investors for the full principal protection they provide against market declines. That is not to say the securities are risk-free, noted a contrarian financial adviser, saying the timing of the trade may not be best in the current market environment.

At maturity the payout of the notes will be par plus any index gain and par if the index falls, according to a 424B2 filing with the Securities and Exchange Commission.

Overbought

“Three and a half years is not terrible, but it’s still too short. A six-year term would have been much better, said Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments.

His reasoning was based on his directional view of global markets, which is bearish.

“Markets in the world, especially in the U.S., are overpriced. Europe is a little bit better but not that much. Most developed markets right now are still at or near their all-time highs.

“When you buy at such highs you’re taking on more risk,” he said.

The FTSE 100 index has fallen by about 8% since its January high. But compared to its early 2016 low, the U.K. large-cap benchmark is now up more than 42%, he noted.

“The FTSE 100 is not a bad choice. Right now, the U.K. benefits for a lower pound versus the dollar. It helps their economy. They can pay lower wages while the dollar rates for the goods and services they export hasn’t changed,” he said.

The depreciated currency helps companies’ bottom line, he added.

“It’s good for their economy at least for now. But I don’t think this is going to last,” he said.

For Kaplan, global equity markets will begin to tumble when the overpriced U.S. benchmarks have nowhere to go but down, which he expects is about to happen.

Leading indicator

In the United States, the S&P 500 index after last week’s rally is up 4.8% for the year. Yet it still hasn’t reached its 52-week high of Jan. 26.

“We’re probably already starting to enter a bear market. U.S. benchmarks are hitting resistance except for the Nasdaq,” he said.

Even if the market is trading range bound, the February correction marks the beginning of a downtrend, he added.

The strong economy in the U.S. is not necessarily the sign of a healthy market, at least not when valuations are so high.

“The stock market can be a leading indicator of a recession. It usually comes first,” he said.

“Most analysts will tell you to buy stocks when the economy is strong and the unemployment is low. It’s not always a good time. In fact, you’re better off buying stocks when the economy is in a recession...when the economy is terrible,” he said.

Not only most equity indexes have not returned to their January levels prior to the February pullback but a fewer number of stocks are hitting new 52-week highs since then, he noted.

“This is just the opposite of what we had when the bull market began in March 2009,” he said.

Bear in sight

Since Kaplan thinks the bear market has already started or is about to start, the 3.5-year tenor carries risk given that bear cycles last about two years on average.

“I think we’ll have a bear market reaching a low point in 2020. Then we should see some kind of rebound, which is almost always what happens. But will it be strong enough to bring us back to where we are today?”

While the answer to this question will depend on the intensity of his predicted sell-off as well as on the strength of the rally coming thereafter, Kaplan said there was probably not enough time to score gains at maturity.

Also, the worst has yet to happen. If the U.S. equity markets are now trading range bound, some corner of the world, namely emerging markets (Turkey, India, Brazil) and China are already in bear market territory.

“I would be more interested in buying a structured note on emerging markets,” he said, although he would want to wait before investing in this asset class.

“I’m waiting for U.S. stocks to get lower. It’s likely that at that point emerging markets would drop even more. But in general, it makes sense to buy low. The U.S., Europe and the U.K are not trading low. They’re overpriced. A 3.5-year trade is too risky in my view because you don’t have enough time for a recovery.”

Based on this pessimistic outlook, Kaplan defined the risk involved with the FTSE 100-based notes as “opportunity cost.”

“You don’t have to worry about a bear market. Your investment is protected. But you do have an opportunity risk,” he noted.

“Your money could easily be tied up for 3.5 years with no gain at the end.”

Alternatives

Because Kaplan is bearish on equity, he would rather look for safe returns from U.S. government treasury bonds.

Three-year treasuries yield 2.67%. Investors can expect to get about 10% at the end of three years on a compounded basis.

Treasuries are guaranteed by the U.S. government and interest earnings are exempt from state and local taxes, he noted.

“You don’t have to worry about a crash in the stock market.

“The return is modest but you’re guaranteed to get it if you hold it to maturity, which is what you would do with a structured note anyway.

“Finally, it’s totally liquid. You can sell it anytime you want,” he said.

If investors are worried about interest rate risk, they can buy short-term treasuries and roll them at maturity, he said.

ETFs an option

On the equity side, investors could buy the exchange-traded fund tracking the FTSE 100 index, he said.

Unlike the notes, the ETF would pay investors dividends. Those could also enjoy the liquidity of a fund.

But such option does not provide any safety net.

“If you prefer the principal-protection, government Treasuries are probably the best alternative,” he said.

The notes are guaranteed by Bank of America Corp.

BofA Merrill Lynch is the agent.

The notes are expected to price on July 26.

The Cusip number is 09709TFP1.

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