BofA Finance’s leveraged notes tied to Russell 2000 index seen as bet on tax cuts, slower bull

By Emma Trincal

New York, Nov. 30 – BofA Finance LLC’s 0% Capped Leveraged Index Return Notes linked to the Russell 2000 index due December 2019 represent a mildly bullish bet on the market and hopes of a tax overhaul with a focus on small-cap stocks, likely to harvest greater gains from tax cuts.

The payout at maturity will be par plus double any index gain, up to a capped return of 14% to 18%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 10% and will be exposed to losses beyond 10%.

Tax vote

“This is a play on Trump’s tax reform because the Russell 2000 is made of small companies that are the most likely to benefit from tax cuts,” a market participant said.

“As the tax reform agenda goes through, it will lift the stocks of those smaller companies operating in the U.S. as the economy gets stronger.”

All U.S. benchmarks rallied this week, but some traders scrutinized the Russell 2000 price moves as the Senate began discussing the tax reform bill. The Dow Jones industrial average has jumped more than 3% in the past five days while the S&P 500 and the Russell 2000 have both gained about 1.90%.

The chances of the Senate bill to pass have increased since Thursday after senator John McCain (R-Ariz.) said he would support it.

December pricing

The offering will not price until December, according to the prospectus. Since BofA Merrill Lynch, the agent, closes its calendar at the end of the month, the index can display some volatility in between, the market participant said. But the positive trend if the bill is voted will be set for the next two years, he said.

The four-point range for the cap is designed to help the desk hedge the notes in advance, a structurer said.

“Usually, structuring desks have the tenor, the leverage and the buffer pre-determined. The cap comes as a result based on pricing conditions,” he noted.

Two main products

Leveraged notes distributed by BofA Merrill Lynch tend to come in two flavors, according to data compiled by Prospect News. This one is the more defensive type.

A first type shows 13- or 14-month tenors with triple the gain on the upside, aggressive capping but no protection.

The second one, such as this deal, features longer maturities, reduced leverage, lower caps, but the notes come with a buffer on the downside.

“But structurers will use all these moving parts – longer tenors, less cap, less leverage – to pay for the buffer,” said the structurer.

Moderately up

The buffer has a cost: returns are limited with this note. As the prospectus states, a buyer should expect the index to increase moderately.

At mid-point of the range a 16% cap over two years with a two-to-one exposure is particularly conservative, the market participant said.

“If the tax bill gains traction through Congress, you don’t want to be capped at 16% or even 18%,” he said.

“If we don’t get the tax cuts, then your 10% buffer is going to be useful.

“It really depends on your view. I tend to think that you don’t want to have that cap in your way. I personally don’t see the Russell up only 7% a year.”

Rationale

Elliot Noma, founder of Garrett Asset Management, sees in the notes a combination of two plays – one on the passing of a tax reform; the other on the weakening of the bull market.

“It’s definitely based on the hope of a tax bill. It would help small caps more than large caps,” he said.

Investors in the notes cannot be too bullish, which should be consistent with their market outlook.

“Eight percent is a little bit low,” he said.

“The argument is that you still have a little bit of upside but that we’re close to the end of the bull market. Maybe you have some weakening there taking place.”

Based on such assumptions, investors can easily give up returns above the cap.

Insurance

“The boom has past. We’re probably at the peak of this run and we’re not going to have another year of double-digit returns. That’s the view,” he said.

On the downside, investors in the notes see the real possibility of a pullback.

“They’re saying that there’s downside risk otherwise they ask for a buffer. But they don’t expect a 2008 or 1987 crash,” he said. “They’re buying some insurance on a moderate decline. And they can live with a modest return.

“It’s somewhat of a bearish view since getting that buffer has a cost.

“You give away the big upside gains to buy insurance. That’s the tradeoff.”

Tradeoff

Noma said he probably would not consider this note, having a different outlook on the market.

“I’m a little bit more optimistic. I can see the end of the bull run. But if we have a correction, money will get pulled out and then what? Chances are interest rates will still be low. The Fed may even want to cut rates a little bit if they can in order to ease the market downturn. What do you think people will do then? They’ll go back to the stock market. Money has to go somewhere,” he said.

“It’s perfectly reasonable for somebody to buy a bond like this. If you don’t expect the next two years to be like the past eight years, it makes sense to be willing to sell the upside in order to finance your insurance.”

The notes are guaranteed by Bank of America Corp.

BofA Merrill Lynch is the agent.

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