Bank of America's $15.23 million Mitts linked to renminbi offer full protection, leverage

By Emma Trincal

New York, Feb. 8 - Bank of America Corp.'s $15.23 million of 0% Currency Market Index Target-Term Securities due Feb. 4, 2014 linked to the Chinese renminbi/dollar exchange rate attracted attention last week for their full principal protection on a term of only two years, sources said.

But for sellsiders and currency structurers, the terms are not exceptional given who the issuer is and the choice of underlying.

Investors in the notes need to be bullish on the renminbi relative to the dollar, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus 130% of any increase in the value of the exchange rate measure. If the value of the exchange rate measure decreases, the payout will be par.

"Fifteen million in currencies is a very decent size," a currency-linked notes structurer said.

"The terms are not bad: it's capital guaranteed, no cap, some leverage and a relatively short-term duration.

"But they can do it."

The issuer, Bank of America, which this source said has a higher credit risk than other banks as reflected by its credit default swap spreads, is the main factor behind the attractive terms, according to him.

Funding

"Their funding is really rich," he said. "Bank of America has the highest spreads among all banks."

The two-year CDS spread for this issuer is 210 basis points, he said. In comparison, the spread is 104 bps for Citi and 95 bps for Barclays.

The funding rate reflects the credit risk of the issuer. The wider the spreads are, the higher the perceived risk is and the more investors need to be compensated for it.

The structurer explained that in order to achieve the full principal protection and the 1.3 times upside leverage, the investor had to buy a forex option called put/call, in this case, a "dollar put/CNY call." CNY stands for the Chinese renminbi.

"This option is bearish on the dollar and bullish on the renminbi," he said.

The option is the equivalent of a call on the renminbi since the trade is based on the renminbi/dollar exchange rate.

The call by itself provides the downside protection, he said, since the risk on a call is always limited to the cost of the premium. As a result, investors in the notes are not exposed to any downside participation.

The 1.3 times leverage is achieved by buying 1.3 units of this call, he added.

The currency structurer estimated the cost of this option at 4.8% of the notional based on his own model.

"Bank of America can do it just because their funding is so rich," he said.

The 210 bps CDS spread, quoted per annum, would be the equivalent of a 420 bps spread for the two-year period.

"They probably add that over Libor, which gives you 4.7%. But keep in mind that CDS levels are just an indication. Their real funding has to be higher than that," he said.

Forward

Another factor making the economics of the deal work, he said, is the cost of the options on the Chinese renminbi.

"The cost of the CNY options is relatively cheap because of the forward movements," he said.

Forward contracts involve trades at a specific date in the future. Forward prices illustrate what the market expectations are for a specific asset at a specific future date.

"In the middle of last year, the market expected a 3% appreciation of the renminbi against the dollar for a two-year period. Now the expectation is quite flattish, at around 0.1%," he said.

"Options on the Brazilian real, on the other hand, are very popular. The cost of the same call would probably be 20 cents more for the real. You couldn't replicate that trade with the real," he said.

A sellsider at another firm agreed.

"It's pretty attractive, and it must be what the forward looks like for that currency in particular," he said.

The sellsider said that he is not sure whether the deal was for retail investors or a larger type of account.

"Someone has to have that view that coincides with that structure," he said.

"Because they're able to produce these terms in that structure, the forward for that currency must be very different than others," he said.

The currency structurer said that he did not know demand for forex-linked notes was not greater among retail investors.

"The product worked for the bank too," he said.

"They priced internally through Merrill Lynch, so that's their 1.75% fee.

"The structuring desk may have made 10 cents or 15 cents on it, plus they're making spreads on the options."

Bank of America Merrill Lynch was the underwriter.

The Cusip is 06051P422.

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