Best of are back with Bank of America's $2 million notes tied to best performing basket

By Emma Trincal

Tacoma, Wash., Aug. 24 - Bank of America Corp. priced $2 million of 0% notes due Aug. 22, 2018 linked to the best performing of three baskets, bringing to market a relatively forgotten structure with multiple underlying assets called "best-of," often seen as the opposite and more appealing alternative to worst of, sources said.

Each basket was made up of different weights of the Dow Jones industrial average, the iBoxx $ Investment Grade Corporate Bond Fund and the SPDR Gold Trust, according to a 424B2 filing with the Securities and Exchange Commission.

Basket A contained the equity index with a 55% weight, the investment-grade bond fund with a 35% weight and the gold trust with a 10% weight.

Basket B contained the equity index with a 50% weight, the investment-grade bond fund with a 45% weight and the gold trust with a 5% weight.

Basket C contained the equity index with a 45% weight, the investment-grade bond fund with a 52% weight and the gold trust with a 3% weight.

If the return of the best-performing basket was positive, the payout at maturity would be par plus that basket's return. If the return of the best-performing basket was zero or negative, the payout would be par.

"Allocator notes have been around for a while. We don't see many best of because they're expensive," a market participant said.

"But they're more popular than worst of. We feel that there is a reaction to worst of. It doesn't ring well with clients when you're marketing it."

Conservative play

Worst of often take the form of a reverse convertible tied to multiple assets, in which the barrier can be breached by the worst performing of the assets. At maturity, investors are exposed to the worst performer.

In contrast, the Bank of America product offered full principal protection and the uncapped exposure to the best-performing of three baskets.

"You get the best of the different configurations. You don't have to try to guess which one is the best. They'll give you the best. Obviously, it's a much easier sale than a worst of," an industry source said.

"It takes away the portfolio management decision," another source said.

The notes are mainly designed as a conservative play, the market participant said, noting the inclusion of a fixed-income element as one of the underlying asset classes.

"This is for people who want to stay in the market but are concerned with rising interest rates. They don't want to be caught as rates go back up but they don't want to miss out on a great move in equity," he said.

"It's probably a good trade for a conservative investor given the full principal protection."

"I like that balanced approach," said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

"Bank of America is not on the top of my list [for credit risk] but it's not on the bottom of my list either. I like the best of. If you asked me to pick one of those three baskets, I probably would take a pass. But with this, you know that if the equity markets do well you'll get the best basket; if the bond component is the best, you'll get the basket with the largest bond weighting and same with gold. This would be the equivalent of a balanced fund for a conservative client. It's an OK deal. I like it," he said.

Bond component

According to the prospectus, investors get exposure to the total return of the iBoxx $ Investment Grade Corporate Bond Fund, or the price of the fund plus its dividends. The calculation is computed daily.

"They're giving you a daily total return. LQD pays 4% a year in dividends. In six years, it adds up, the market participant said.

The "LQD" symbol designates the iShares iBoxx $ Investment Grade Corporate Bond Fund, listed on the NYSE Arca.

"The bond allocation will be the biggest determinants on how it plays out," said Kalscheur.

That's because the biggest differential between asset class weightings is with bonds, he noted, pointing to the 17% difference in weightings between basket A and basket C.

"I also like very much the full principal protection on the downside in addition to the uncapped upside," he said.

"You are giving up the 2.5% dividend on the Dow Jones. But since the allocation is only about 50%, you're giving up only half of that. For the ibbox it looks like they're taking care of it. And the gold ETF does not have dividends," said Kalscheur.

Rainbow

If best of deals are rare, it's because they are difficult to price in this market environment, sources said.

Issuers use rainbow options, whose payouts depend on more than one underlying asset. The principal protection adds to the structuring cost.

"If you're willing to wait around for six years and get the best at the end, it's a reasonable note," said Steve Doucette, financial adviser at Proctor Financial.

"It seems like they're trying to emulate a nice diversified portfolio - stocks, bonds, commodities. The packaging may be appealing for a lot of folks. My biggest concern is the long duration. Too many things can happen in six years," he said.

"With full principal protection, you need to have longer duration and this rainbow option is slightly more expensive because you need to get the flexibility of the proportions," said Tim Mortimer, managing director of Future Value Consultants.

Interest rates, exotic options, volatility are not the only main factors behind the construction of those products. Correlation is a key ingredient as well for the pricing of rainbow options, a New York structurer said. It also makes the product slightly more complex than it seems.

"The best of concept is not that simple because you have the correlation between the baskets, and you also have the correlation within the basket. It's a tricky concept," the structurer said.

"Inside the basket, you want correlation between the asset classes otherwise each asset class would cancel each other out, he added.

"But between the baskets, you want a low or even better, a negative correlation. If baskets A, B, C are perfectly correlated, what's the point of having the choice? The point of having the choice is to get the best one. If they all move the same way, why would I buy the best? Why not buying just one of them?

"It takes a while to explain these concepts to an investor," he said.

The basket A is the basket with the greatest volatility and historically the best performance, noted the market participant. Changes in the value of the Dow Jones Industrial index, the most heavily weighted component, could have the biggest impact on performance, he said.

But a sellsider noted that the percentage weightings were not that different.

"You want the widest dispersion as possible because you want to have the best performance. If the weighting for each asset class is the same, it's barely worth the effort. You are a locking yourself in a product that moves with the market," he said.

The structurer noted that the difference between the different Dow Jones weightings was "only" 10%.

"With the maximum weighting at 55%, you know that 45% will always be there. Since it's the largest component, by giving you the best of the three, the variability is not that much. The option is not that expensive.

"There's nothing wrong with that. You know you'll always have at least 45% invested in the Dow Jones. It's clever. That's the combination they gave you with that price and you have to assume that they're doing it at the right price. There is no such thing as a bad product," he said.

Structurers have to strike a balance between costs and terms, a market source said.

"You take three different baskets, you get the best. If it's negatively correlated, if there is massive dispersion, it's great for the investor, but it comes at a higher cost," he said.

"Because they made the weightings quite similar between the baskets, in other words, because it's fairly correlated, the option is cheaper."

For some buysiders, the issue of pricing is best left to the issuers. What they like about the product are simple features, such as principal protection and portfolio allocation.

Allocator notes

"Correlation is a different conversation," said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

"I do like it. I like the full principal protection. It's attractive to me. These are the classic three core asset classes that investors are looking for.

"If we anticipate an improvement in the economy the first basket with the largest exposure to the Dow Jones should be the best," he said.

Medeiros was particularly interested in the product as a portfolio optimizer tool.

"If you want to be a successful money manager, you need to understand how these securities work together. This note gives you a solid infrastructure with three different asset classes that reflect the broad base of the market," he said.

"I can use this as my principal protected core, which gives me the peace of mind to focus on my alpha drivers as part of my satellite allocation.

"People are looking for protection. Even the plain vanilla asset classes have been exposed to tremendous volatility.

"I expect that we'll see more and more of these products," he said.

Bank of America Merrill Lynch was the underwriter.

The notes (Cusip: 06048WNB2) carried a 2.5% fee.

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