Bank of America's leveraged notes tied to real estate index may offer growth but no dividend

By Emma Trincal

New York, Nov. 15 - Investors in Bank of America Corp.'s upcoming 0% Capped Leveraged Index Return Notes due May 2013 linked to the Dow Jones U.S. Real Estate index need to weigh the pros and cons of getting exposure to real estate investment trusts without the benefit of earning the high dividends often associated with those securities, sources said.

"If you want access to REITs and real estate, this note is a terrific way to do it as long as you understand that you're giving up yield," a financial adviser said.

The payout at maturity will be par of $10 plus double any percentage increase in the index, subject to a maximum return of 36% to 40% that will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by 10% or less and will lose 1% for every 1% that it declines beyond 10%.

The underlying index is a subset of the Dow Jones U.S. index made of REITs and shares of real estate companies.

The cons

John Gabriel, an exchange-traded fund analyst at Morningstar, said that giving up dividends is too high a price to pay as cheaper and better alternatives are available to investors.

"The notes will actually track a price return index. So the value of the dividends will not be reflected in the performance," he said.

"The IRY ETF offers nearly 4% annualized yield. You're not getting that with the note, and that's one of the attractive aspects of the sector," he added.

The ticker symbol "IRY" designates the iShares Dow Jones U.S. Real Estate ETF, which tracks the underlying index used in the notes.

"Liquidity and credit risks could also be issues. The notes won't trade on any exchange, so investors will have to commit their capital for the entire 18-month period. If there is any concern over Bank of America's credit quality in the interim, investors will not have an avenue to sell their notes," he said.

"In my opinion, the cons related to the limitations of the notes along with the liquidity and credit risks outweigh the pros of limited downside protection and capped leveraged upside."

Gabriel said that buying the ETF is a better alternative.

One advantage, he said, is the "low" cost of the iShares Dow Jones U.S. Real Estate ETF with a 0.47% expense ratio.

"If the downside protection is what you find attractive in the notes, you can buy a put to give yourself a capped downside," he said.

"For the leverage, I wouldn't recommend the leveraged ETF because they reset daily and offer no protection at all.

"But you could certainly get leverage using a margin account.

"However you do it, my initial reaction is there might be a better way to get your exposure on your own."

The pros

For the financial adviser, the benefits of the structure more than compensate for the loss of dividends if investors hold a moderately bullish outlook on the index.

They just have to understand the product.

"It looks like an attractive note to me," he said. "Whether you want to choose the real estate index as a sector to invest money in, that's your choice."

"As long as you know that you're not getting the dividend. As long as you understand what the main holdings are, as long as you feel that you can make money in the sector, this note is a terrific way to get exposure to REITs."

The underlying index, while not a total return index, still offers a growth opportunity, according to this adviser.

"Because REITs have to pay dividends, the index may appreciate as people go after REITs for more income," he said.

"I don't think you'll have a runaway index, and if you don't expect an astronomical growth, I think you're better off with the notes than with buying the REITs directly or the ETF."

Not too moderate

The financial adviser noted that while growth does not have to be "astronomical," it should exceed 6% over the period in order for the notes to "break even" with the ETF.

That's because investors are giving up the 4% annualized yield offered by the ETF when they invest in the structured product.

"The 4% yield is nice. I agree," he said.

"But if the index closes down 8%, you're down 2% with the ETF and you're back at zero with the notes. You're still ahead.

"If the index is down 20%, you lose 14% with the ETF and only 10% with the notes."

An investor may also find it difficult to replicate the leverage feature, he said.

"The leverage you have with the notes is quite attractive too. It's two times the upside, and there's no downside leverage unlike a leveraged ETF," he said.

"If you had to buy it on margin, it would be a lot of work. Plus if the index was to plunge, you would get a margin call. You would have a loss on the position or you would have to sell out other investments."

After the rally

One thing that was clear to both the adviser and the analyst is that the notes are not designed for overly bullish investors.

Because they double up their return, buyers of the product should expect a maximum annualized return of 24% to 26.66% from their investment with only half of this performance - or 12% to 13.33% - coming from the index itself, according to the prospectus.

In the suitability section, the prospectus said that investors should expect the index to increase "moderately."

These levels are indeed "moderate" compared to the recent history of this index in the aftermath of the housing bubble, said Gabriel.

From March 2009 to July 2011, the Dow Jones U.S. Real Estate index grew by nearly 90% on an annualized basis.

"Following 2008 into 2009, the REITs were among the worse-performing assets. They were the hit the hardest," he said.

"They were priced for disaster because the sector was overly leveraged.

"Then in March 2009 when the market hit bottom, they snapped back. They moved from being bankruptcy risk to outperforming the rest of the market."

But in July, the index dropped and has been volatile since then.

"We've moved from a huge rally to more uncertainty," he said.

The notes will price and settle in November.

Bank of America Merrill Lynch is the underwriter.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.