Bank of America's notes tied to politically risky markets offer poor risk/return trade-off

By Emma Trincal

New York, Aug. 1 - Bank of America Corp.'s upcoming 0% Capped Leveraged Index Return Notes due August 2013 linked to a basket of three indexes do not offer a satisfying risk/return trade-off, financial advisers said, given the political and market risks embedded in the three indexes that constitute the underlying basket.

The basket contains the Hang Seng China Enterprises index with a 33.34% weight, the Bovespa index with a 33.33% weight and the Russian Depository index with a weight of 33.33%, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus double any basket gain, subject to a maximum return of 16% to 20%. This represents an 8% to 10% basket return before applying the leverage, which would be a performance of 4% to 5% a year.

Investors will receive par if the basket falls by up to 10% and will be exposed to any decline beyond 10%.

The Hang Seng China Enterprises index tracks the performance of the H-shares of 40 Chinese enterprises. H-shares are Hong Kong-listed shares, traded in Hong Kong dollars, of Chinese state-owned enterprises.

The Bovespa is the equity benchmark for the Brazilian stock market.

The Russian Depositary index tracks the most actively traded depositary receipts on the blue chip stocks of the Russian stock market traded on the London Stock Exchange.

Three volatile markets

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he "would probably not be interested in the notes" given the volatility of the markets represented by the three index components.

His main concern is the downside.

"You're talking about three countries that are pretty volatile. You put them all together and you have a huge volatility. With two times leverage, you'll exceed the 10% buffer in a heartbeat," he said.

"These indexes will reflect the problems in these countries," he added, analyzing his concerns with two of the three: China and Russia.

"I'm not so comfortable with China," he said. "First, there's the political risk. China is an abnormality. It's a communist country with no political freedom that has incorporated capitalism in a state-controlled economy. So far, they have succeeded, but no one knows for how long.

"And from a market standpoint, their economy appears to be overheated. They're very concerned about inflation.

"Russia is another problem. There's a lot of corruption. Foreign investors don't want to put their money there. Russia is still a mess. It's still like Chicago in the '20s.

"I'm much more comfortable with Brazil, a country that's becoming more and more a developed country with a strong economy and much more political stability."

Indexing issue

In addition to the volatility that exists in the three stock markets, Kunhardt said that he is not comfortable with the index components.

"An index is a passive investment and as such, its performance depends less on the underlying securities and more on the way it's constructed," he said.

"When you're talking about emerging markets, you're going to find a lot of inefficiencies in the index methodologies.

"I would want to know how those indexes are constructed, how they're managed, and what type of rebalancing you have. There are a lot of unanswered questions there before I can be comfortable in the indexes themselves."

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that the risk profile of the underlying countries, especially the political risk, is too high for the type of limited return offered to the investor.

On the positive side, he said that he likes the creditworthiness of Bank of America and the 10% buffer to protect the downside, although he would have preferred a bigger buffer in the 15% to 20% range.

Kalscheur said that the notes may be a good fit for investors with a particularly good knowledge of those markets.

"Those indexes are off the beaten path," he said.

"It may be a great opportunity if you know China and Russia and think that you understand those markets and know what the risks are.

"But I would stay away from these markets because of the unknowns."

China and Russia

While Brazil is pretty "straightforward," Kalscheur said that he is mostly concerned with China and Russia.

One concern with the Hang Seng China Enterprises index, he said, is that it gives investors exposure to Chinese state-owned companies with potential conflicts of interest in regard to the way the indexes are defined, in particular concerning market capitalization rules.

In Russia, the rules and requirements regarding disclosure imposed on companies are not as stringent as in the United States, he said.

"You've got political risk and market risk."

Russia in his view is the country that poses the greatest political risk among the three, closely followed by China and then "far down" by Brazil.

Cap

"My problem is the risk/return profile of the notes," Kalscheur said.

"These markets are much more volatile than any developed country market," he noted.

The leverage and the cap make this investment suitable only for a moderately bullish investor, according to the prospectus.

Kalscheur noted that all an investor needs in order to maximize the basket's return is a gain of 4% to 5% a year.

"To cap it out at that level just doesn't seem to give me enough upside to be really excited about it," he said. "If I'm going to take on so much risk, I want my upside to be much higher.

"To get 8% to 10% a year, I can simply go into the U.S. equity market. I understand it more and it would be much safer.

"This is not a bad product, but the cap is just too tight. If those markets rally, they can easily generate 30% to 50% in two years. You should have a cap of at least 15% with that basket."

Plain vanilla ice cream

But even a higher cap may not be enough for Kalscheur, who said that he would not consider the notes because he prefers products that are more "straightforward."

"Plain vanilla tastes good. It's still ice cream," he said.

"Keep it simple and low cost and easy to understand instead of trying to create something new and exciting which at the end of the day may not make a lot of money to your clients."

The notes will price and settle in September.

Bank of America Merrill Lynch is the agent.

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