BofA’s $20.2 million Mitts on commodities offer full protection, but volatility a concern

By Emma Trincal

New York, April 28 – BofA Finance LLC’s $20.2 million of 0% Market Index Target-Term Securities due April 17, 2025 linked to a basket of four commodity futures contracts provide full principal-protection and uncapped leverage, but advisers are concerned about the volatility and valuations of the underlying commodities, especially crude oil.

The basket is comprised of equal weights of the WTI crude oil futures contract, natural gas futures contract, corn futures contract and soybeans futures contract, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus 135% of any basket gain.

If the basket falls, the payout will be par.

Steve Doucette, financial adviser at Proctor Financial, was intrigued by the selection criteria of the basket components.

“They picked energy and agriculture. That makes sense given the inflation. But why wheat and soybeans? Why not wheat and radish?” he said.

Doucette said his main concern would be the natural gas and oil contracts in the basket.

“Agriculture commodities are not as volatile as energy. You have to pay attention to oil prices. If the war in Ukraine is over, oil could really collapse.

“Of course, if inflation persists, both agriculture and energy commodities could continue to go up. But it’s hard to make predictions for this asset class.”

Risk of no return

Equity markets are easier to evaluate, he noted.

“No one can predict the market in general, but with equities you get a better idea of what the next three years may look like. Energy is totally unpredictable. There are too many geopolitical factors that come into play and volatility is high. Three years out, oil prices could go down considerably,” he said.

The principal protection was one of the most attractive aspects of the structure.

“You don’t have market risk exposure at maturity. You only have the credit risk,” he said.

Investors however run the risk of not earning any return on their investment if the basket finishes negative.

“That’s the problem with leverage. It works in a bull market. But if you have very low returns, it doesn’t really help. And if your return is negative, you’ve tied your assets for three years and got nothing,” he said.

Mostly bullish

For investors who are bullish on commodities, the notes may be a valid option.

“If you truly believe that inflation is going to continue for a while, then it makes sense to have commodities exposure.”

When the market value of a leveraged note increases during the life of the security, Doucette routinely considers selling it in the secondary market.

“If two years into it the market it’s up, we would try to get out of it,” he said.

One drawback was the small number of basket components and their limitation to two types of commodities.

“I would still prefer to have a broader commodity index so I can minimize the volatility. Even though you have the full downside protection, too much volatility can really compromise your return,” he said.

“You never want to be tied to something to get zero.”

If he had to rearrange the terms, Doucette would probably look for a more bullish version of the notes.

“I could make the protection 95% instead of 100% to capture some excess leverage. I don’t know how much more leverage I may get. But it would be nice to get an extra 15% leverage on the upside in exchange for giving up 5% on the downside,” he said.

While the note is bullish, its principal-protection feature may catch the attention of risk-averse clients too.

“For very conservative investors, it may be a way to capture some potential return without any market risk,” he said.

That contango issue

Steven Foldes, wealth manager and founder at Evensky & Katz / Foldes Financial Wealth Management, said that he typically does not invest in commodities.

“We prefer to buy shares of companies that produce commodities, oil company stocks for instance,” he said.

His main concern with the asset class was the negative roll yield that a long position in commodities futures contracts may create.

“If the market is in contango, it erodes your return pretty significantly,” he said.

Commodities futures contracts used for trading need to be rolled when they expire. Shorter-dated contracts need to be sold to buy new contracts at a later expiration date.

Contango refers to the cost of rolling futures contracts when shorter-dated contracts and spot prices are lower than longer-dated contracts. A market in contango generates a cost that cuts the performance of the underlying. That’s because the contracts maturing further into the future are now priced higher than the expiring ones.

“The negative roll yield can really eat up the performance of your note. You can easily disappoint the client,” he said.

If for instance oil prices went up from $120 a barrel to $135, the increase may not be reflected in performance of the notes.

“Very few investors understand the complexity of rolling futures contracts. So, we stay out if it for the most part,” he said.

Foldes said his exposure to commodities is indirect.

“We do it via stocks of commodities producers, which are highly correlated to the underlying commodity without the issues of contango.”

Another concern with the underlying basket was its low diversification with half of the allocation going to energy.

“It’s not unusual. Most commodities indices are overweight energy. But right now, we are cautious about oil,” he said.

“Oil prices have gone up so high, we may already be close to a peak. Everybody wants to buy oil.”

This trend has been exacerbated by the war in Ukraine leading the U.S. to ban imports of Russian oil, he explained.

Another important factor has been the reduction in U.S. oil output as producers had to cut back drilling when oil was below $40 a barrel during the early stages of the Covid-19 pandemic in 2020.

“The post-Covid pent-up demand has pushed prices higher. And you now have Russia, which is a big wildcard.

“Oil companies have not yet met this demand, but they will because that’s what they do. They will increase production and oil prices will go down. Ultimately, we will reach a new equilibrium,” he said.

This cycle may not bode well for investors choosing to get energy exposure at the present time, he noted.

“Oil is not far from historical highs. Am I really going to buy this basket at the top of the market?” he said.

In addition, oil is known for its erratic and ample price moves.

From a price below $20 two years ago, WTI crude oil is now trading at $105.

The moves go in both directions.

In less than two years, from June 2014 to February 2016, the price of the WTI crude oil contract fell by nearly two thirds to $38 from $105.

“The volatility of oil is high. Valuation is a challenge. We don’t think it’s a reasonable time to get exposure to this asset class,” he said.

The notes are guaranteed by Bank of America Corp.

BofA Securities Inc. is the underwriter.

The notes will settle on Friday.

The Cusip number is 09710F496.

The fee is 2.25%.

© 2015 Prospect News.
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