BofA’s capped leveraged index return notes linked to MSCI EM need higher cap, advisers say

By Emma Trincal

New York, Aug. 9 – BofA Finance LLC’s 0% capped leveraged index return notes due August 2020 linked to the MSCI Emerging Markets index offer a lot of what advisers are looking for with double upside leverage and a 10% buffer for downside protection The only problem is the cap, which bulls or reasonably bullish advisers said is too low.

The exact cap, to be set at pricing, will be between 18% and 22%, according to a 424B2 filing with the Securities and Exchange Commission.

On the watch list

Steve Doucette, financial adviser with Proctor Financial, said he is especially interested in emerging markets right now as their performance has been lagging that of United States markets for a long time.

“I like emerging markets because it’s an underperforming asset class. That’s why I’m more concerned about the cap than the leverage,” he said.

He calculated the annualized compounded return for the 18% to 22% cap range as between 8.66% and 10.45%.

“I look at the cap and I don’t want to be capped out at less than 10% a year,” he said.

Hard buffer

The buffer on the other hand was a favorable piece of the structure.

“In two years the market may start turning and if it’s the case, emerging markets will drop with the rest of the world.

“They may even drop more: in 2008, the S&P 500 index fell 37% when the MSCI Emerging Markets index lost half of its value.

“So the buffer...I like. That’s why I always push to have a hard protection. Some people are comfortable with a soft protection. I’m not...It’s a timing thing.”

By “soft protection” he was referring to a barrier, which once it is breached, no longer offers any protection unlike a buffer.

Performance laggard

The protection was a good thing to have. But Doucette was more preoccupied with the upside risk.

“In the last 10 years, the emerging markets haven’t done anything. They’ve underperformed the S&P almost every year except in 2017 when they had a huge run,” he said.

Indeed, since 2008 there have been only two years when emerging markets significantly outperformed the S&P 500 index. In 2009, the S&P 500 rose by 26.5% while the MSCI Emerging Markets index surged by 72%.

Another banner year was 2017 when the MSCI Emerging Markets index gained 36.4%, surpassing the S&P 500 by nearly 15 percentage points. The MSCI Emerging Markets index was a couple of points higher than the S&P in 2012 but otherwise it has been lagging the domestic index most of the time. This year for instance, the MSCI Emerging Markets is down 7.5% while the S&P 500 is up 2.5%.

Another tradeoff

“When you see those huge spreads between emerging markets and the U.S. you have to be bullish. I believe in mean reversion so I expect higher returns that this cap. Of course that’s if we don’t hit the bear in the next two year,” he said.

“But if the market continues to go up, emerging markets will catch up and you don’t want a low cap.”

Doucette said he was willing to reduce the leverage in order to raise the cap or even eliminate it.

“If you keep the buffer, even without leverage this note would be a reasonable play as long as you can increase the cap. The U.S. has been outperforming a lot for a long time. We’re due for a reversal.”

Some headwinds

Matt Medeiros, president and chief executive of the Institute for Wealth Management, was also bullish but also cautious.

“The large-cap domestic market has performed the best for some time. These emerging markets and non-U.S. stocks meanwhile have underperformed,” he said.

“So it’s important in a portfolio to have some exposure to emerging markets. In a core portfolio you could have something like a 5% allocation to it.”

The MSCI Emerging Markets index however faces some headwinds, which is why Medeiros said the presence of a buffer is beneficial to investors.

“I’m somewhere between neutral and bullish. But you have to pay attention to some headline risks. The trade talk has already taken its toll on some of the non-U.S. stocks, especially emerging markets stocks. They’ve taken a bit of a hit,” he said.

Too easy to hit

Medeiros however remained optimistic on the index.

“I don’t see emerging markets having the type of rally they had last year. But they should produce some decent growth going forward.

“Assuming that trade talks and currency talks do not overwhelm this opportunity, I think the two times leverage as it pertains to the note should have expanded the cap a little bit higher.”

He was referring to how big a return, when multiplied by the leverage, will be needed to reach the cap.

If the cap is 18% for instance, the index will only have to rise by 4.4% a year to bring the notes’ return to its upside limit. Conversely, the 22% cap can be achieved with as little as 5.35% in annual growth in the underlying.

“You’re getting capped out too easily. You don’t even have to be bullish to expect hitting this cap, which means it’s somewhat a bit too restrictive,” He said.

“It’s an interesting note for an emerging markets allocation but I wish it would have a bit of a higher cap.”

The notes will be guaranteed by Bank of America Corp.

BofA Merrill Lynch is the agent.

The notes will price in August and settle in September.

© 2015 Prospect News.
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