Bank of America's Mitts linked to Dow give high protection, but risk lies with the issuer

By Emma Trincal

New York, Oct. 21 - Bank of America Corp.'s 0% Market Index Target-Term Securities due October 2014 linked to the Dow Jones industrial average protect up to 90% of investors' principal but still subject them to the credit risk of this issuer over three years, which is a factor to be considered when making the investment decision, said structured products analyst Suzi Hampson with Future Value Consultants.

If the final level of the index is greater than the initial index level, the payout at maturity will be par of $10 plus the index return, capped at 50% to 60%, according to an FWP filing with the Securities and Exchange Commission.

Investors will share in losses of up to 10%.

"You can't lose more than 10% on the downside, and your upside is capped at 50% to 60%. This is aimed at the more cautious investor who wants to restrict the amount of capital that may be lost," she said.

"But there's a price for that, and that's the cap."

Future Value Consultants used a 57.5% cap to compute its report, which is 75% of the cap range mentioned in the prospectus.

Low risk

The level of risk, as measured by riskmap, is "moderate," Hampson said.

The riskmap is a Future Value Consultants rating that measures the risk associated with a product on a scale from zero to 10. The higher the riskmap, the higher the risk of the product.

The riskmap is the sum of two risk scores on the same scale: market riskmap and credit riskmap.

The riskmap for this product is 3.78, slightly higher than the average 2.92 for similar products using the same type of structure. But it is lower than the 5.45 average for all products, she said.

"That could be because the volatility of the Dow Jones Industrial was somewhat higher when the terms were set for these notes, or it could be that similar structures use a slightly less volatile underlying," she said.

"But it's pretty average when you compare this with similar products also giving high protection levels."

On the other hand, the riskmap difference in favor of this product compared to all others is the result of the high downside protection level in these notes, she said.

"All over products" would include reverse convertibles, leveraged return notes and other risky products.

The capital protection offered by this product translates into a much lower market riskmap, at 1.73, compared to the 4.98 market riskmap for all products, she said.

CDS spread

"You have a reasonably low market risk," said Hampson.

"The risk is not coming from market risk. It's coming from the credit riskmap, which is a combination of the three-year term and the issuer.

"When you have a short-term note, the credit risk doesn't have such an impact. But it does here."

The five-year credit default swap spread for Bank of America is currently 370 basis points. It is just a little bit less than Morgan Stanley at 384 bps, she said.

But Bank of America has a wide CDS spread at the moment, reflecting a high cost of insuring the debt due to the perception of credit default risk, she explained.

The notes' return score, 7.53, is better than the average of all products but worse than products of the same type, she said.

The return score is Future Value Consultants' opinion of the risk-adjusted return under reasonable and consistent forward-looking assumptions for underlying asset evolution on a scale of zero to 10.

A high return score means that the return compared to the risk is high.

For the calculation of this score, Future Value Consultants uses five key assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. The firm calculates a risk-adjusted average return for each assumption. The return score is the best of these five returns.

Best assumption

"With this type of structure, the high-growth scenario is the best because since your capital is protected, you don't really care [about] having a low-volatility environment, you want as much growth as possible, at least as close to the cap as possible," she said.

The probability table associated with this product shows that the odds of incurring a loss versus making a profit are 53% and 47%, respectively.

But this table is based on a "neutral growth" assumption. When the model changes the scenario from "neutral" to "high growth," the probabilities change too.

Investors in such case only have a 28% chance of losing capital versus a 72% chance of a positive return. The entire probability of a loss is only concentrated in one bucket: an annual loss comprised between zero and 5%, as a result of the buffer.

On the other hand, the highest probability for the gains is for an annualized return between 10% and 15%, where the probability is 21.4%.

"What this tells you is that while you have some chances of losing money, the amount you may lose is very restricted," said Hampson.

From this probability table, which uses the best assumption, Future Value Consultants computes its return score.

Lower return

At 7.53, the product's return score is lower than similar products with an average 8.08 score.

"They're taking into account the riskmap, and you have a higher riskmap here due to the higher credit risk," she said.

"Based on the risk you're taking, you should be offered a higher return. That's what it means."

Reciprocally, since the riskmap for those notes is much lower than the average of all products, the notes also received a better return score than the 6.10 score given to all products.

"If you compare this with capital-at-risk products, you're getting a decent return for the risk incurred," she said.

Good price

One positive aspect of this product is its pricing score, she said.

The notes have a price score of 8.06, about equal to similar products scoring 8.05.

Based on a scale of zero to 10, the score represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis and profit margins on the underlying derivative.

"This rating is used to compare your product with similar ones," she said. "In this case, the product is fairly priced.

"You want to make sure that the price is around the average, which suggests that the product is competitive. You don't want a price score lower than similar products, as it would mean that you're not getting the best."

Future Value Consultants offers its opinion on the quality of a deal with its overall score, the average of the price score and the return score.

The notes have a 7.79 overall score, slightly less than 8.07, the average score for similar products.

Hampson said that the gap was due to the notes' lower return score.

"You have a product with a low risk profile since you're getting almost all your principal back," she said.

"But the investor has to consider the credit element of this deal, especially over a three-year period.

"Even if you have 100% of your capital protected, you're still subject to the issuer's ability to repay you at the end."

The notes are expected to price in October and settle in November.

Bank of America Merrill Lynch is the underwriter.

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