Bank of America's Mitts linked to index basket offer global equity exposure with low risk

By Emma Trincal

New York, June 10 - Bank of America Corp.'s 0% Market Index Target-Term Securities due June 2017 linked to a basket of three indexes are designed for investors seeking diversified exposure to international equity with as little risk as possible, said Suzi Hampson, structured products analyst at Future Value Consultants.

The underlying indexes are the S&P 500 index with a 45% weight, the MSCI EAFE index with a 27.5% weight and the MSCI Emerging Markets index with a 27.5% weight, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus any gain in the basket, subject to a cap of 55% to 65%. If the basket falls, the payout will be par.

Limited risk

The asset exposure period is six years for the investor, which adds some credit risk compared to other types of structures as well as a greater opportunity cost if no gains are generated at maturity, said Hampson.

But given the principal protection, risk is limited, she said, as measured by riskmap.

Riskmap, a Future Value Consultants rating, measures the risk associated with a product on a scale from zero to 10. The higher the riskmap, the higher the risk of the product.

The rating compares the average product underperformance relative to cash with the average underperformance of five sample assets of different volatility levels. The riskmap rating equates the risk of the products against the five hypothetical assets.

This product has a 2.96 riskmap, which is much lower than the 5.18 average riskmap for all recently rated products in a variety of structures.

"Naturally, the principal protection considerably lowers the risk here," said Hampson, notably market risk.

Market and credit

Riskmap is broken down into a market riskmap and a credit riskmap.

The market riskmap is based on the same calculation used for the overall riskmap but ignoring issuer credit risk, explained Hampson.

The product received a very low market risk score at 1.31, which is less than comparable products (2.05) and even lower than all products (4.76), she noted.

The difference in market risk between those notes and the average structured product is easy to appreciate, Hampson said.

"Only fully principal-protected notes give you your entire principal back at maturity. And we don't see a lot of these in the market. Most other products are capital at risk," she said.

Principal-protected notes, however, contain another form of risk, she said: "You could end up with no gains at maturity."

This risk is also measured by riskmap. If investors were to get nothing but their principal back at maturity, the notes' overall performance would be less than the risk-free rate of return, she said.

"The result would be a loss compared to cash, in other words, a higher riskmap," said Hampson.

The credit riskmap is the difference between the total riskmap and the market riskmap. It scores the issuer's credit risk, itself a function of the credit default swap spreads of the issuer, which represent the cost of insurance against the issuer's default.

Bank of America has a CDS spread of 145 basis points, which is more than some foreign banks such as Deutsche Bank (100 bps) and UBS (100 bps) but in line with other U.S. banks such as Goldman Sachs (150 bps) and Morgan Stanley (150 bps).

The credit riskmap for the notes at 1.65 is more than that of similar structures (1.30).

"This is probably because the other issuers of principal-protected notes carry more credit risk," said Hampson.

Credit risk is also much higher than the average product at 0.42. All those various products include a variety of structures, some of which with very short terms like reverse convertibles, Hampson noted.

"You have a duration factor here. It's a six year, and that's quite long compared to a three-month reverse convertible. The longer the term, the greater the credit risk," she said.

Fair cap

The notes are capped at 55% to 65% for the six years, so approximately 10% per annum based on Future Value Consultants' methodology of using the cap at 75% of the range.

"Is the cap level generous? It's fair," said Hampson, who explained how to assess it.

"You want to compare the potential return with two things: first, the risk-free rate of return, and second, the return you should get for taking on the issuer's credit risk," she said.

The risk-free rate for six years, based on the equivalent U.S. Treasury bond yield, is 1.9%, she said, or 2% approximately.

The CDS spread of 150 bps represents the minimum return an investor should get for being exposed to the issuer's credit risk, she said.

"You end up with a minimum rate of return of 3.5% below which it's not worth investing in the notes," she said.

"The difference between that 3.5% minimum rate and your 10% cap is pretty wide. That's why it's safe to say that this is a good cap. It's fair."

Risk-adjusted return

The return score for this product at 7.38 is elevated compared to the average score for structured notes Future Value Consultants has recently rated, which is 6.09.

The return score is Future Value Consultants' opinion of the risk-adjusted return under reasonable and consistent forward-looking assumptions for underlying asset evolution.

"Your return score really measures whether your return is adequate for the amount of risk you're taking on," she said.

It might be counterintuitive that the return score of this very low-risk product with capped return would be greater than that of a riskier note with more upside potential.

"It's just very relative. The return score quantifies the balance between risk and return based on the investor's preferred trade-off," said Hampson.

Chances to gain

The high return score is illustrated by the probability table of return outcomes, which displays the various probabilities of returns across different return buckets.

Investors in the notes have a 79% chance of earning zero to 5% per year. But their probability of hitting the top return bucket of 5% to 10% a year is only 21%, according to the chart.

"The biggest probability of 79% includes everything or almost everything - from a negative performance, which will earn you nothing, to small growth or no growth," she said.

"That's why the 0% to 5% return bucket is the one with the highest probability.

"On the loss side, the probability is zero due to the principal protection."

The price score at 7.49 is higher than both similarly structured products and the average recently rated product.

The price score is Future Value Consultants' estimate of the total costs taken out of the product from direct fees and profit margin on the underlying derivative.

"These notes represent real value to the investor compared to other products," said Hampson.

The overall score at 7.43 is just about the same as the 7.42 rating of similar products but is much higher than the average note, which received a 5.95 score.

The overall score is Future Value Consultants' opinion on the quality of a deal based on the average of the price score and the return score.

"Both the price and the return are good, so you have a high overall score," said Hampson.

The securities will price in June and settle in July.

Bank of America Merrill Lynch is the underwriter.

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