BofA Finance’s $150,000 notes on S&P 500 Daily Risk Control offer full protection, no cap

By Emma Trincal

New York, Dec. 4 – BofA Finance LLC’s $150,000 of 0% notes due Nov. 28, 2024 linked to the S&P 500 Daily Risk Control 5% USD Excess Return index give investors full protection against market declines while offering unlimited return potential.

If the index return is positive, the payout at maturity will be par plus 110% of the index return, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, the payout will be par.

The issuer was able to offer the uncapped upside with leverage by taking advantage of a risk-control index.

The S&P 500 Risk Control Indices relies on a methodology using algorithms to control the risk of the index.

The index seeks to maintain a 5% volatility level by dynamically adjusting exposure to the S&P 500 Total Return Index on a daily basis, according to the prospectus.

Vol. and leverage

An industry source said the issuer could have used more leverage.

“The volatility of the S&P 500 is about 13 right now. So, you’re dealing with an index that’s at least 2.6 times less volatile than the S&P. This should significantly lower the cost of your calls,” he said.

Leveraged payouts are built though the purchase of call options with an at-the-money strike, which means that the leverage is applied from the initial price.

In addition, investors in the notes do not get the same return they would obtain from investing directly in the S&P 500 Total Return index, he noted.

Based on the five-year term, the risk-free rate, which determines the price of the zero-coupon bond used to structure the downside protection as well as the price of the call options, he determined that leverage could have been offered at a 1.5 times rate.

Cautiously bullish

Matt Rosenberg, sales trader at Halo Investing, disagreed saying that for a five-year note, being able to provide full downside protection while keeping the upside uncapped was attractive.

“I’m going to assume you’re not getting the dividends, just like you wouldn’t get the dividends from the S&P. For structures like that, the issuer definitely needs the dividends,” he said.

“But I think it’s attractive because it’s conservative. You don’t have to worry about losing principal as a result of a market pullback. And at the same time, you’re not capped.

“You’re investing in the 100% protection but you’re still bullish on the market, so having unlimited upside is a good way to express that view.”

Investors are “hungry” for principal protection in this highly valued stock market, he said. But principal-protected notes, which are built on zero-coupon bonds, are hard to price due to low interest rates, putting limits on how much options can be bought for pricing.

Better alternative

“You get principal protection via those proprietary quantitative investment strategies, which target a certain volatility level, just like this one,” he said.

“Or if you do it on the S&P 500, you’re going to have to be subject to a cap.

“I’d rather buy that than a capped note on the S&P 500.

“Roughly, I would say you have the choice: you either buy an S&P note with a 100% participation up to a cap of 35%. Or you do this deal as an alternative: 110% participation, uncapped.

In some instances, a risk-control strategy may dampen returns as volatility is capped, which may cause the algorithm to increase allocations to safe assets such as cash.

Asked whether investors should be concerned about the impact of the volatility target on performance, he said that it all depended on the investor’s outlook on the market.

For a bullish investor, the uncapped upside by far outweighed the possible underperformance of the underlying.

Besides it remained to be seen whether the risk control could cause the underlying to underperform the S&P 500 index in a meaningful way.

“This alternate version of the S&P has to be highly correlated to the S&P 500,” he said. He assumed as an example, a coefficient of correlation of 0.85 between the two indexes.

“Let’s say the S&P is up 20% a year just for the sake of an example. That’s 100% in five years. With this note, I’m up 85% based on the correlation. Apply to that the 1.1x leverage and my return is 93.5%.

“It significantly outperforms an S&P note capped at 35% with a participation rate of 100%.

“If you’re cautiously bullish on the S&P, this is a very compelling deal.”

The notes are guaranteed by Bank of America Corp.

BofA Merrill Lynch is the agent.

The notes (Cusip: 09709TXD8) settled on Nov. 27.

The fee is 3%.

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