Bank of America's three-year step-up notes linked to four indexes offer global equity exposure

By Emma Trincal

New York, Sept. 12 - Bank of America Corp.'s 0% market-linked step-up notes due September 2016 linked to a basket of indexes are aimed at investors seeking a diversified global equity exposure, sources said.

The notes will outperform if the basket growth is subdued, a financial adviser said. But strong bulls would not be penalized given the uncapped upside, a portfolio manager noted.

The basket includes equal weights of the S&P 500 index, the Russell 2000 index, the MSCI EAFE index and the MSCI Emerging Markets index, according to an FWP filing with the Securities and Exchange Commission.

If the basket's final level is greater than the step-up value, the payout at maturity will be par of $10 plus the basket return. The step-up value is expected to be 112% to 118% of the initial basket level.

If the basket's final level is less than or equal to the step-up level but greater than or equal to the initial level, the payout will be par plus the step-up return, which is expected to be 12% to 18.

If the final basket level is less than the initial level but declines by no more than 5%, the payout will be par. Otherwise, investors will lose 1% for every 1% that the basket declines beyond 5%.

The exact step-up value and step-up return will be set at pricing.

Break it down

The composition of the basket could maybe be improved upon, said Steve Doucette, financial adviser at Proctor Financial, adding that the structure offers more appeal to investors who expect the underlying indexes to trade in a range.

"It's a globally diversified basket. That's fine. And I like the three-year term," Doucette said.

"They only put a 5% buffer. It's a little bit of protection in case the market pulls back.

"But we custom tailor our notes based on index buckets. The S&P 500 has been the outperforming index. I'm not sure that I would want all those indexes in there. Your excess performance is if the basket trades sideways. The 118% step level is 6% a year. Quite frankly, if you think that over three years the market will not deliver more than 6% a year, you're not very bullish."

The structure would "work" if the underlying indexes in the basket were to trade range bound, he said. Otherwise, the benefit of the step-up payment would be lost and investors in the notes would just be long the underlying indexes minus dividends, he said.

"I'd pull some of the money away from the international indexes - the EAFE and the emerging markets. That's just because they've been the underperforming indexes and I expect a reverse to the means - in other words, stronger growth," he said.

"On the other hand, I might do it with the S&P and the Russell because they've outperformed a lot and their growth may not be as strong. We're almost five years into a bull market run in the U.S. There is more potential to benefit from these notes with the two big runners. So I would break it down."

The Russell 2000 is up more than 24% this year while the S&P 500 has gained 18% and the MSCI EAFE index, 10%. The MSCI Emerging Markets index, however, is down nearly 8% for the year.

"The 5% buffer is a little bit small. We'd like a little more buffer underneath the U.S. indexes," he said.

Global exposure

Jim Delaney, portfolio manager at Market Strategies Management, said that he likes the notes for the access they offer investors to a global equity portfolio. How bullish an investor has to be is less relevant because upside returns are not limited, according to him.

"I think an 18% return in these four indexes in three years is a given. That's only 6% a year," he said.

"It's good from the point of view that there is no cap.

"Certainly, you will do well if the market trades sideways, if it's less than 6% a year. I don't think it's going to happen.

"So what's the benefit of having that step-up? For one thing, you get the full upside. You're not penalized by a cap. Secondly, if you're wrong and if growth tends to be sluggish, you'll get this nice boost, so it gives you some sort of protection on the upside too, so to speak, just in case your view was too bullish and the market turns out to be flat."

Delaney said that the 5% buffer is "nice to have" and makes the deal "more attractive," but added that it is probably not necessary.

"I don't think it comes into play. The downside protection is not going to be triggered," he said.

"It's really a nice way to get exposure to global growth. You have all the upside. You have some downside protection.

"I can see that people would use it if they think the market will go sideways. More of a value to me is that it gives you a blended growth exposure to international equity and it doesn't cap the upside. That's why I'd buy it."

The three-year term is an important aspect of the structure that investors should focus on, he added.

"The value of this deal depends on how you value liquidity. In your portfolio, some holdings will have a pretty long-term horizon. If I'm a retail investor allocating holdings to short-term, long-term investments, this would be a good investment to put in the medium-term part of my portfolio.

"You should be comfortable having your money tied for three years.

"The only time it makes me nervous is if there is a cap on it. But because there is no cap, I feel more comfortable with the three-year time horizon.

"Also I wouldn't put all my money in there."

Delaney said that he likes the composition of the basket.

"It's a nice allocation: half U.S., half international; 50% in the U.S., 25% in Europe and developed markets and 25% in emerging markets," he said.

"I think that blend will definitely beat 12% in three years. But if it doesn't, if it ends anywhere between zero growth and 12%, I'm still making 12%. I get a pillow to fall on."

Delaney said that he is bullish on the global economy, which should be a condition to invest in the notes.

"All those benchmarks are recognized, institutionally focused indexes. It's not like investing in an ETF for homebuilders. China is slow but is not going down. Emerging market growth is picking up. Europe is coming out of a recession.

"Out of all those indexes included in the basket, the one that I'd consider the most risky would be the S&P. The economy is recovering, and I see the Russell continuing to outperform the S&P. Same thing for emerging markets. But even if the S&P loses momentum, I don't believe it will affect my performance. I firmly believe that the S&P will be up by more than 12% in three years and that the three other indexes will outperform the S&P.

"But again, if I'm wrong, if I'm too bullish, it's nice to have the step-up."

BofA Merrill Lynch is the agent.

The notes will price in September and settle in October.

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