Bank of America's notes tied to financial stocks may not offer best structure for sector play

By Emma Trincal

New York, May 15 - Bank of America Corp.'s 0% Accelerated Return Notes due July 2013 linked to a basket of three financial stocks may not offer the best risk/return profile to investors, sources said. They stressed that current volatility in the financial sector may lead to strong moves both up and down, which the structure of the note may not be able to monetize or hedge given its cap and lack of downside protection.

The underlying companies are Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co., according to an FWP filing with the Securities and Exchange Commission. They companies have weights of 33.33%, 33.33% and 33.34%, respectively.

The payout at maturity will be par of $10.00 plus triple any gain in the basket, up to a maximum payout of $12.20 to $12.60 per note. The exact cap will be set at pricing. Investors will be exposed to any decline.

According to the prospectus, the notes are designed for investors anticipating only moderate growth in the basket of financial stocks. Assuming a cap set mid-point at 24% for the 14-month term, the equivalent maximum return per annum would be 20.5%.

In order to hit the cap, investors would only need to see the underlying basket grow by about 7% per year.

At the same time, investors have no downside protection, noted Dean Zayed, chief executive officer at Brookstone Capital Management. To him, this represents a major problem.

Headline risk

"The timing is great isn't it?" he said, referring to the $2 billion loss announced on Thursday by JPMorgan chief executive officer Jamie Dimon.

The stock price has plunged 11% since the disclosure.

"With so much uncertainty around the financial sector and given what's happening with JPMorgan, it's not a very attractive note to me, especially without the downside protection," Zayed said.

"Financials can be in for a really tough summer. I'm not sure the risk is worth it in this case."

Zayed said that a note linked to an index or fund of financial stocks would have been more attractive as less exposure would have been concentrated around one name.

"Financials as a whole are going to get hurt, especially if more bad news is coming out of JPMorgan. They have lost a lot of money. It could be a lot more," he said.

"You have three times leverage on the upside. That's good, but you're fully exposed to losses on the downside. I don't think that the reward pays off for the amount of risk you're taking."

Getting protection

If investors are worried about "contagion" from JPMorgan stock on the sector, the leveraged note with full downside risk may not offer the best instrument, a portfolio manager said.

"If you need protection, call writing is better for you," he said.

He offered a general example not based on the basket but on one of its three components: the share price of Citigroup, currently trading at about $28.

An investor selling a one-year at-the-money call on Citigroup would receive a $4.70 premium, which is the about the equivalent of a 15% return.

"If nothing happens or if the stock goes up, I still make 15% from my premium," he said.

"And if the stock is down, I lose ... but I have 15% protection on the first losses.

"So say Citi is up 5%. I make 15% with the three-times leveraged note and I also make 15% with the call writing.

"If Citi goes down 5%, I lose 5% with the note and I make 10% selling the call, since I have this 15% return."

For investors concerned about volatility in the financial sector, the notes are "too bullishly oriented," he said.

"In order to pick up some extra return, investors in this product have no choice but to give up all downside protection," he said.

Writing a call gives investors not only more protection, he said. It also gives them liquidity.

"The basket could be up 10% during the term and finish down to zero and you haven't picked up the 10% gain. Plus, you're giving up dividends," he said.

Asked whether JPMorgan's recently disclosed loss could have a contagious impact on other financial stocks, he said that "there's always a risk," but "the market is pricing it a lot higher than it is."

"If you're that concerned about headline and market risk, you should write a call instead," he said. "At least you get the downside protection."

Punitive cap

Perhaps more problematic in his view is the amount of potential gain an investor in the notes may give up due to the cap.

"If you're bullish, the leveraged note may really hurt your upside," he said.

He took the example of Citigroup again and surveyed the analysts covering the stock.

He said that among the roughly 20 analysts covering the stock, the lowest one-year price target was Credit Agricole's $31 per share and the highest was Oppenheimer's $51 target price. The $31 to $51 one-year target price range represents an upside of 10% to 80% from the current stock price, he noted. But the investors in the notes are not going to benefit from more than a 7% upward move, he noted.

"If you're bullish, you just buy the stock," he said.

That is precisely what Dick Bove, financial stock analyst at Rochdale Research, recommends investors do with JPMorgan in a research note released Tuesday called "Simply Absurd."

The analyst reiterated his buy rating on JPMorgan with a $58 one-year target price, a 60% increase from Tuesday's $36 share price.

In the note, Bove wrote that despite a $2.5 billion litigation charge in the first quarter, an expected $2 billion trading charge in the second quarter and a projected $1 billion loss in the third quarter, JPMorgan is still expected to earn $18.1 billion in 2012.

"The $18.1 billion profit projection is expected to be the highest amount earned by any American bank this year," he wrote.

For Bove, the $2 billion loss, the media reaction to it and the regulatory woes to come for the bank are simply new buying opportunities for investors.

The notes are expected to price in May and settle in June.

Bank of America Merrill Lynch will be the agent.

The fees are 2%.

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