BofA Finance’s $3.27 million leveraged notes on Defense ETF lack upside potential, protection

By Emma Trincal

New York, March 8 – BofA Finance LLC’s $3.27 million of 0% Accelerated Return Notes due April 25, 2025 linked to the iShares U.S. Aerospace & Defense ETF did not provide investors with a satisfying risk-adjusted return given the overvalued underlying, the limited upside and the lack of downside protection, a contrarian investor said.

The payout at maturity will be par of $10 plus triple any ETF gain, subject to a maximum payout of par plus 13.73%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be exposed to any ETF decline.

Low cap

“The ETF is trading at very high levels. It may be related to the conflicts in the world. But the note itself is poorly designed,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

“Having three-times leverage is not going to help if you have that cap,” he said.

“I’d rather have one-to-one and no cap with some downside protection.”

The 13.73% maximum return over the 14-month tenor is the equivalent of an annualized compounded return of 11.7%. The ETF would only have to rise 3.91% a year to cap the upside.

“The leverage is a waste because you are capped at a very low level. It’s a bet on a very narrow window,” he said.

One-to-one down

But more troublesome part was the absence of any barrier or buffer.

“There’s a lot of downside risk,” he said.

The ETF scored its 52-week low on Oct. 6 at $102.02.

“The price could go back to that level. Anytime you have a recent price move you can always go back there,” he said.

“In general, anything going up so quickly can also go down very quickly.”

Indeed, the share price rose more than 25% from its October low to the initial level of $127.88 on the trade date.

“If we revisited the October low, we would be talking about a loss of more than 20%. And you have no protection,” he said.

All-time high

Another risk factor was the timing of the trade looking back at a longer observation period. The share price is the highest since the fund’s inception on May 2006.

“You’re taking huge risks getting in this at such high levels,” he said.

“The ETF is overvalued. Unfortunately, this is not an isolated case. There’s nothing special about this fund except perhaps the fact that there are geopolitical crises around the world, so people expect the defense sector to be hot.

“But most sectors are overvalued. The market as a whole has some kind of a problem.”

Risk-reward

The risk-reward of the investments showed some limitations.

“I wouldn’t expect big gains from the ETF because one, it’s overvalued, and two, there’s this low cap. If you’re not going to have a big gain, should you really be exposed to big losses?

“The potential loss here is bigger than the gain.

“It makes no sense,” he said.

Some advisers see in the leverage a way to reduce risk. The leverage, they argue, allows investors to put a smaller amount of money to work in order to control a greater notional amount.

“It doesn’t matter how much you put in and the size of your position. It’s still risky. If you put 100 and lose 100, you lose 100%,” he said.

Overvalued

Kaplan examined some of the fundamentals of the fund, including for some of the top holdings.

He first looked at the price-per-earnings of the ETF, which is 30.98%.

“There is no way these companies’ profits are growing 31% a year. Not at that kind of a rate,” he said.

Separately the price-to-book ratio, which measures the valuation of a company relative to its book value, was another red flag for the value investor.

“The price-to-book is 3.42. It’s a very high number. You want that number to be below 1,” he said.

Inside information

Also of concern was the concentration of the ETF, which only consisted of 35 holdings.

The top holding – RTX Corp. – had a 17.2% weighting. When combined with the second and third components – Boeing Co. and Lockheed Martin Corp. – the top three had a weighting of 40.5%.

Kaplan also checked insider trading, which is one important test in his investment process.

“Some of RTX’s top executives have recently been selling a substantial amount of their own shares,” he said.

“Those people know the company inside out. Too much selling is indicative of potential problems.”

RTX president Eddie Shane sold last month $3.233 million in shares valued at $91.05, according to J3 Information Services Group.

“He owned 49,147 shares prior to this sale. He’s now down to 6,741. He got rid of almost all of his shares. That tells you something,” he said.

Don’t buy a story

Kaplan said the structure lacked the potential for growth while exposing investors to full downside risk.

“I’m not sure why you would be looking into this. People should be much more discriminating,” he said.

“It looks like investors are getting excited by what’s happening in the world. With all the wars and conflicts, they expect defense contractors to make more money. They like the story. They’re buying the defense ETF. But they’re not looking at what they’re paying for it. People like stories. They don’t care about data and facts.”

Back to drawing board

Kaplan said the notes could have been better structured.

“I’m sure there are plenty of other ways to do that. Maybe an autocall would have been a better play. At least you are getting some income and some downside protection,” he said.

“I would get rid of the leverage and replace it with a barrier or a buffer.”

“I would keep the short duration. I would leave the 14-month as is.

“But everything else is unappealing... the leverage, the cap, the lack of protection...the whole structure would need a makeover.”

The notes are guaranteed by Bank of America Corp.

BofA Securities, Inc. is the underwriter.

The notes settled on Thursday.

The Cusip number is 09710N523.

The fee is 1.75%.

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