BofA’s notes linked to S&P 500 Daily Risk Control 10% may drag performance but also protect

By Emma Trincal

New York, Oct. 15 – BofA Finance LLC’s 0% notes due Oct. 29, 2021 linked to the S&P 500 Daily Risk Control 10% USD Excess Return index could appeal to nervous investors focusing on the risk of market declines, sources said. But the gains may be limited due to the low volatility strategy employed by the algorithm that commends the returns of the underlying index.

If the index return is positive, the payout at maturity will be par plus the index return, according to a 424B2 filing with the Securities and Exchange Commission.

If the index is flat or falls, investors will receive par.

The S&P 500 Daily Risk Control 10% USD Excess Return index is a volatility-controlled excess return version of the S&P 500 Total Return index. It provides market exposure while maintaining a 10% volatility level by dynamically adjusting exposure to the S&P 500 Total Return index on a daily basis.

Plus and minus

Using a low-volatility index is a double-edge sword, according to Carl Kunhardt, wealth adviser at Quest Capital Management, who said he would not consider the notes except for some particularly nervous clients.

“People always associate volatility spikes with big market declines. But volatility has a sign in front of it. It can be a minus sign. It can also be a plus sign,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

A low volatility underlying will cushion losses, an advantage if the market is down, he said. But what if the market is gaining?

Low expectations

Kunhardt said he does not expect the S&P 500 index to rally as it did over the past few years.

“My outlook is very moderate. I’m not bearish but I’m not expecting very high returns. Some analysts see gains between 0 and 1%. We’re not that pessimistic but our expectations aren’t high either. I would say my outlook is in the mid-single-digits...5% maybe more.”

In such scenario, an algorithmic index capping volatility daily could cut already mediocre market gains even further, he argued.

“It’s muting your volatility on the upside just as much as it’s muting your volatility on the downside,” he said.

“Over three years you’ll have spikes of volatility pushing market prices upward.

“The only reason for being in equities is to capture these upside spikes.

“With a low volatility index, you won’t.”

Do-it-yourself

Kunhardt said he is confident in his muted outlook for stocks, downplaying the risk of market losses over a three-year period.

“Over a three-year period is what happened last week relevant? Does anyone know of a bear market lasting three years?” he said.

The S&P 500 index dropped 4.1% last week.

“It’s relevant to have this protection in some cases though.... for instance, if last week’s sell-off happened when the notes mature, it may have some relevance.”

Overall however Kunhardt said he would much rather buy an exchange-traded fund tracking the S&P 500 index and balancing his own portfolio between cash and equity rather than having an index doing it automatically based on a volatility target.

Hand holding

“Let’s not take our eyes off the long-term,” he said.

Kunhardt however said he would consider the notes when dealing with very risk-averse investors.

“Some clients are very anxious about losing money. I have to respect their risk position. If I’m dealing with these clients, I have two choices. I can find some way to mute volatility so they’ll feel comfortable staying in the market. Or I can be in cash. I would consider this note, which is option number one, because I don’t want my client to go in cash.”

Time is your friend

Jerry Verseput, president of Veripax Financial Management, said he somehow liked the notes, including the full downside protection. But he was concerned about not getting enough upside return as well.

“If you went five or six years, they would apply leverage. There’s full protection. That’s great. But with a note based on a low volatility strategy, I would want to see some leverage on the upside.

“If you go longer, you can get it,” he said.

Sister deal

In fact, BofA Finance LLC is prepping a similar note – same underlying index and full downside protection – according to a separate 424B2 filing with the SEC. However, this other issue offers a 125% upside participation rate over a five-year tenor.

“I would like that one better,” said Verseput.

“If this is going to be an equity replacement then you should have at least five years of time horizon.

“If you’re trying short-term trading profits, the short-term horizon is fine.

“But as an adviser, my job is to get people to retirement or help them stay retirees.”

Adding some fuel

The underlying index is “by nature a very quiet performer,” he said.

The returns from a volatility controlled index “are not going to keep up with expectations.”

“If an investor needs 5% or 6% as a minimum to retire, I would hesitate to put them in this note without the leverage.

“But by going longer and getting the leverage, it becomes a much more attractive investment for that client.”

The notes are guaranteed by Bank of America Corp.

BofA Merrill Lynch is the agent.

The notes (Cusip: 09709TKS9) will price on Oct. 26 and settle on Oct. 29.

The six-year notes (Cusip: 09709TKW0) will price and settle at the same time.

BofA Merrill Lynch is also the agent for this longer-dated deal.

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