Bank of America's upcoming notes on China/Brazil basket offer capped bet on moderate growth

By Emma Trincal

New York, May 4 - Bank of America Corp.'s upcoming Accelerated Return Notes linked to the FTSE/Xinhua China 25 and Bovespa indexes represents an option for investors who do not anticipate high growth in the Chinese and Brazilian equity markets given the capped and leveraged structure, sources said.

Bank of America plans to price 0% Accelerated Return Notes due July 2011 based on a basket containing equal weights of the indexes, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus triple any gain in the basket, up to maximum of $11.65 to $12.05 per note. The exact cap will be set at pricing.

Investors will be exposed to any losses.

Leveraged participation

One of the advantages of the notes, according to the preliminary term sheet, is to provide a leveraged return for equity investors who want to participate in the growth of those two emerging markets.

The return is capped though, which makes the investment only suitable for investors anticipating that the value of the basket will increase "moderately" at the end of the 14-month term, according to the term sheet.

Assuming for instance that the cap is set at around 21%, investors need to see the underlying basket grow by 7% in order to capture the maximum return.

Unlike other leveraged and capped notes, the product does not offer any buffer protecting a portion of the principal on the downside, sources noted. As stated in the term sheet, "there is no guaranteed return of principal," even partially.

Cap and volatility

Bradley Kay, exchange-traded fund analyst at Morningstar, said that investing in a capped structure, especially one that provides three times leverage, is standard and does not pose a problem in itself.

But in this case, the cap may be a concern for investors given two combined factors: the relatively high volatility of the underlying indexes and the fact that there is no downside protection in the structure.

"The big issue here is that with China and Brazil, you're dealing with fairly volatile equity markets," Kay said.

"And while those markets can have immense runs like what we've seen last year, they can also collapse like in 2008 for instance."

Brazil's Bovespa stock index lost 52% in 2008 and gained 71% last year.

The iShares FTSE/Xinhua China 25 index fund was down 24% in 2008 but gained 36% in 2009.

In the year to date, the Bovespa index and the iShares FTSE/Xinhua China 25 ETF are down 6% and 7.3%, respectively.

"What you're paying for with the cap is the leverage as you're betting on a moderate upside. But you have no downside protection. And with higher volatility, you really want to avoid the cap. You need those incredibly high returns during the bull market to make up for the large downfall," Kay said.

Kay said that the leveraged and capped structure with no buffer would make much more sense with a less volatile underlying such as the S&P 500.

"With U.S. stocks, you have greater odds of getting 7%, and your chances of hitting the maximum return of 21% would be magnified," he said.

"With the Chinese or Brazilian stock markets, you have a much wider dispersion of returns. Being capped on the upside while keeping the downside dispersion could end up poorly for you," said Kay.

"You're placing a fairly heavy bet that those markets are going to have a moderate growth, but the risk of them falling quite a lot is not really taken into account," he added.

Price of leverage

Others said that leverage increases the cost of the structure for the investors.

A buysider, based on the same 21% cap assumption, said that investors may be giving up too much of the upside.

"I am not too sure I would want to be capped on the upside and not on the downside," he added.

In order to design this type of product, the bank sells a call option at a 21% strike price above the market price, this source explained. The bank then uses the premium it receives to finance the cost of borrowing for the leverage, he added.

"Since we're dealing with very volatile markets, the price of the option is probably very high and so the bank will earn a pretty good premium. Obviously, what they'll have to pay to borrow money is going to be much less than that premium" he said.

He added that with the difference, the bank "is also likely to buy a put," to ensure its own downside protection.

This buysider, who is with a hedge fund specializing in emerging markets, said banks get paid for putting together the structure and their profit depends on how well the deal is hedged.

In this case, the difference between the payment received on the call premium and the cost of borrowing the securities in order to provide a leveraged return will allow the bank to finance its structural costs and to get paid on the deal.

"But my point is, if you're a moderately bullish investor in emerging markets, why paying for this structure with a cap? Why not doing it yourself or putting your money elsewhere?"

Fear index

Some investors also paid attention to market considerations when looking at the note.

For some, investing short term in emerging markets may be too risky at the present time given the European debt crisis and the uncertainty around China's potential rate hikes in the near term as a monetary policy response to inflation threats.

Ferenc Sanderson, chief operating officer at Cranwood Capital Management, a hedge fund in Rocky River, Ohio, said, "People are worried that the problems in Greece might impact other countries, such as Spain and the U.K."

He noted that the CBOE Volatility index moved up over the last couple of weeks.

On Tuesday, the VIX index was up more than 18%. A rise in the VIX, also called the "fear index," signals more volatility ahead.

"There is this fear of a contagion. People are reducing risk in general," Sanderson said.

In addition, Sanderson said that he would be cautious about investing in China at this time.

"There is anxiety about inflation and a real estate bubble, and people are starting to wonder whether it's not a little bit too late to stop the overheating of the economy. And yet, they have to control inflation," he said.

By contrast, Sanderson said that the Brazilian equity market offered a more attractive picture.

"Obviously they don't have the fiscal issue a lot of developed countries have. And they benefit from a lot of natural resources," he said.

"I like China and Brazil as a long-term investor," said Sanderson. "But a 14-month investment is very short term, and I'm bearish short term."

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

Merrill Lynch, Pierce, Fenner & Smith Inc. and First Republic Securities Co. LLC are the agents.

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