Bank of America's $101.14 million notes linked to S&P drew large bid for market timing feature

By Emma Trincal

New York, Sept. 5 - Bank of America Corp.'s $101.14 million issue of 0% Accelerated Return Notes due Aug. 29, 2014 linked to the S&P 500 index was the most popular deal last week. Sources offering one explanation for the bid: the inclusion of an exotic option called lookback, which allows investors to time their entry point more efficiently.

The payout at maturity will be par of $10 plus 300% of the index return if the index return is positive, subject to a maximum return of 24.8%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is negative, investors will be fully exposed to the decline.

A lookback option offers a floating strike that is set only after the issuance date.

Market timing tool

According to the prospectus, the initial S&P 500 index level will be the index's lowest closing level from the pricing date through Oct. 30.

Because the deal priced on Aug. 30, the feature, called a lookback, gives investors two months to secure the best entry point, sources said.

The lookback is an exotic option. It is more expensive than a plain-vanilla option, sources said, but it also appeals to investors.

"That may be one of the reasons why it was such a big deal with the uncertainty going on. People are bullish, but they are also concerned about a correction," an industry source said.

A market participant said that the notes were designed for bulls slightly worried about short-term volatility.

"It's been done before. It's a popular structure, especially when the market has rallied. The lookback definitely helped the size," he said.

These deals are for people who want exposure to the market but also want to better time the trade, he added.

"When the market goes up a little bit like now and you have a long-term view that's bullish but realize that there is a lot of uncertainty around with the ECB, the German constitutional vote and the U.S. elections coming up, a lookback can be attractive. You're trying to avoid buyer's remorse," the market participant said.

The industry source said that the lookback option offers some appeal to undecided investors in today's environment.

"The idea is don't try to pick the bottom, we'll pick the bottom for you. It's designed to help you pick the bottom for the next two months," he said.

"You may like the market, but you may still worry. Of course, you can always wait, but the market may go the other way or market conditions may change, the volatility or the interest rates may be different."

Exotic is not cheap

Another type of lookback option is more commonly used in the structured products space, this industry source said.

"I haven't seen this type of lookback in structured products, although I've seen people using it in the OTC market with derivatives and options - but not with registered notes," he noted.

Lookbacks can be of two types, he added.

"The first one, used here, sets the strike at the lowest point. The other type, which is more common with structured notes, sets the reference at the highest point," he said.

The lookback gives investor more control over the trade as they can secure the best initial price.

"With a plain vanilla option, you put in the trade, but a lot of things could go wrong," the market participant said.

"You may want to be long the S&P, but what if the S&P went down? This is the type of deal that financial advisers like to sell because it doesn't require a complicated explanation. It's actually easy to understand," he said.

If lookback options are not that common with structured products, it's because they may be difficult to price, the market participant said.

"It's hard to do. You pay for the lookback options. It takes a little bit of the participation or the cap," he said.

The industry source said that the lookback option used in the deal is not among the most expensive.

Some lookback options determine the final strike price only at maturity, he explained, while the strike in this product is set after the first two months.

"You go to the lowest point for the first two months, obviously not for the two-year term. It's a two-month, not a two-year lookback. The shorter the period, the cheaper the option," he said.

"However, you still have to pay for it. Without this feature, you would have had better terms.

"I don't think the lookback alone is what made it such a big deal. It was also probably the right timing and the terms in general.

"Overall, it's a good structure. The lookback makes it just more attractive."

The market participant said that another way to optimize the entry point could be to offer similar deals more frequently. But a large offering at the end of the month was more efficient, he said.

"In theory, you could be set up to do series of these notes weekly. But it wouldn't work. A trade is put in immediately on the first week of the month, and then on the second and third week you have the marketing. Pricing weekly would not be efficient to do. With this, you get a pretty good size, and for the client, it's a way of averaging," he said.

Bank of America Merrill Lynch was the agent.

The deal priced on Aug. 30.

The notes (Cusip: 06051R725) had a 2% fee.

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