Bank of America's callable notes offer bet on performance of stocks relative to Treasuries

By Emma Trincal

New York, March 1 - An upcoming note linked to a relative value index gives investors who anticipate stocks will perform better than Treasuries the opportunity to capture an attractive return, sources said.

Bank of America Corp. plans to price one-year 0% Relative Value Strategic Accelerated Redemption Securities linked to the SPDR S&P 500 ETF Trust/iShares Barclays 20+ Year Treasury Bond Fund Long-Short index, according to an FWP filing with the Securities and Exchange Commission.

The level of the index will increase when the performance of the SPDR S&P 500 ETF trust exceeds the performance of the iShares Barclays 20+ Year Treasury Bond fund, and it will decrease when the performance of the Treasury fund exceeds the performance of the equity fund.

If the index closes at or above the initial index level on any of three call observation dates, the notes will be called at par of $10 plus a premium of 11% to 15% per year. The observation dates are expected to fall in September 2011, December 2011 and March 2012. The exact premium and dates will be set at pricing.

If the notes are not called, the payout at maturity will be par plus the index return. Because the last call observation date is also the final valuation date, if the notes are not called, the index return will be negative and investors will lose principal at maturity.

Relative value and beta

"It's an excellent deal," said Eric Greschner, portfolio manager at Regatta Research & Money Management, who added that he liked the notion of a return based on the spread between two returns.

For one thing, relative value decreases volatility, he noted.

"Whenever you're looking at the relative performance between two assets, the beta of the relative performance will be lower than an absolute investment," he said.

With a lower beta, returns could be lessened, but that's when the digital payout structure becomes an attractive aspect of the deal.

Digital call premium

"The digital structure increases the coupon associated to the performance. If you think your underlying index is going to rise but only at a mild to moderate pace, you're better off with a digital structure that offers a fixed but very large coupon rather than a variable return," Greschner said.

"It's also a smart play because the market has appreciated so much, it is not sustainable. You can argue to a reverse of the mean," he added.

Early business cycle play

Greschner also said that the notes were timely from a business cycle standpoint.

"We're at the early stage of growth. Both employment and earnings should improve but slowly. As a result, stocks should continue to rise but not substantially and interest rates will go up but only gradually. So it's a nice strategy for this particular time of the business cycle," Greschner said.

"It would be a dangerous structure at the end of the recovery cycle when interest rates could be rising and the magnitude of stock losses could be potentially worse. I don't think we're there yet. It's only one year."

Structure

Finally, Greschner pointed to aspects of the structure that he said were attractive.

"I like that you can get called even if the index stays the same without having to be above the initial value. By applying a lower threshold, you get a requirement that's easier to meet," he said.

The call feature is also a plus, he said, despite the reinvestment risk associated with the early redemption.

"I like that if it's called, you get a great premium and you get your money back sooner," he said.

"There is always reinvestment risk, but if interest rates rise, you can reinvest your funds at a higher rate."

Downside risk

For other financial advisers, though, the deal represented too much risk.

Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management, said, "It's not something that I would buy because of the lack of protection.

"If we get a downturn and stocks fall and bonds rally, then you could lose a significant amount of money. And that would be a concern. It's even more of a concern after a rally like the one we've had."

On the other hand, "it's not clear what the strategy would do with inflation," he said.

"You have to have a view about where the stocks and the bonds are going, if the economy goes up or down and what does it mean for stocks and bonds and figure out the return profile and do the math. It's a little bit more risk than I would want to take."

The notes will price in March or April.

Merrill Lynch, Pierce, Fenner & Smith Inc. is the agent.

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