Bank of America's notes tied to three stocks show high return potential, elevated risk

By Emma Trincal

New York, Dec. 21 - Bank of America Corp.'s 0% Accelerated Return Notes due January 2015 linked to a basket of three equally weighted financial sector stocks give investors a very concentrated exposure to financial stocks with a high risk profile but an attractive return potential for aggressive investors, said Suzi Hampson, structured products analyst at Future Value Consultants.

The underlying companies are Citigroup Inc., American International Group, Inc. and Goldman Sachs Group, Inc., according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10.00 plus triple any gain in the basket, up to a maximum return of 36% to 40%.

Investors will be exposed to any losses.

"Here is an example of a high-risk, high potential return product," she said.

"These notes have received good ratings from us, which indicates that even for risky products, you can find high scores as long as the return reflects the amount of risk."

Financial exposure

One unusual element of the structure was the underlying - a simple basket of three stocks. Unlike many underlying stock baskets, she said, this one showed very little diversification, focusing on financials, one sector only.

"You have to examine the correlation between the three names as well as each stock's volatility," she said. "We have in this basket stocks that are very much correlated."

The one-year historical correlation between Goldman Sachs and Citigroup is 73%, she said.

"It's quite high."

However AIG showed less correlation with the two other stocks at 44%, she noted.

In terms of volatility, each stock had a high volatility in the 30% to 36% range, she added.

"Although this basket is very concentrated and made of relatively volatile stocks with a high correlation to one another, as far as risk, it is probably less risky than a single stock underlying," she said.

"This is a product aimed at investors looking for exposure to the financial sector with somewhat a bit more diversification than a single financial stock.

"But you do have more concentration than with an index or ETF in the financial sector because an ETF or an index could have hundreds of names," she said.

The issuer may have chosen a concentrated basket rather than an index or ETF in order to make the terms more attractive, she said.

"If you compare this mini-basket with a broader one, this one may be less expensive to hedge and therefore may give you better terms.

"Although an ETF would have been less expensive as well, its volatility may not have been sufficient to give you the room to price competitive terms similar to what you're getting here with the cap and the gearing," she said.

The stock selection probably played an important part in the way the issuer was able to enhance returns with these notes, she said.

"They probably picked three names that must have been easy to price, enabling them to offer the best terms. This could be the result of the correlation between the stocks or their individual volatility or a combination of the two," she said.

"Also there is no barrier and no buffer on the downside, which gives you a lot of leeway to raise the cap."

Bulls across the board

Leveraged notes are designed for bullish investors but the degree of bullishness varies depending on the terms.

With this product, the picture is somewhat of a mixed bag, she said. Ultimately though, the notes are a better fit for the more aggressive investor.

"You have a three-time gearing, which would make you think that this is not a product designed for the overly bullish investor. But this kind of conclusion is often based on the lower cap often associated with high leverage. It's not what we have here. Both the cap and the leverage factor are high in this product," she said.

"This payout could be of interest to of a wide variety of bullish investors. However, it's likely that you're going to capture the most bullish investors with a note that doesn't give you any downside protection. If you think the basket return may be flat or range bound, you wouldn't go for this type of product. Besides, a very bullish investor would not object to that type of cap. Assuming you hit the 40% maximum return, that's pretty easy to digest and it doesn't represent too much of a compromise even for those investors with high return expectations," she said.

High risk

Given the absence of any barrier or buffer, the notes are risky, she said, based on riskmap, a Future Value Consultants' rating. Riskmap measures on a scale of zero to 10 the risk associated with a product, with 10 being the highest level of risk. The score is the sum of two risk components: market risk and credit risk.

The riskmap, at 5.25, is higher by almost two points than the 3.89 riskmap for the average of the same product type, according to Future Value Consultants' report.

The same product type in this case refers to all leveraged notes with or without downside protection.

The relative excess risk of the note compared to its peers is entirely the result of market risk, she said.

With a 0.90 credit riskmap, there's virtually no credit risk differential as the average credit riskmap is 0.92. On the other hand, the 4.34 market riskmap is much greater than the average for the same product type of 2.97.

"We're at the higher end of the riskmap spectrum with this product. This is due to the selection of a basket for underlying, which is going to be volatile if you compare it to the S&P or an ETF," she said.

Risk reward

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions - neutral assumption, high and low growth environments, and high and low volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The return score of 7.72 is slightly higher than comparable products averaging 7.32, she observed. However, it is considerably better than the market as a whole, which shows a 6.62 score for all product types.

"It suggests that some products, as it is the case here, can combine a high-risk level with a good return score. It all depends on what the potential upside is in relation to the risk," she said.

"The return score is not considerably better than other leveraged notes because it incorporates the potential for high losses both in terms of size and probabilities.

"The loss potential is not negligible," she said.

Under the best scenario - high growth here, investors have a 12.5% chance of losing more than 15% per annum, which would represent 30% or more in loss of principal.

"That's quite high," she said.

"And yet the return score is pretty high too, it's above average.

"Under the same market assumption, our model shows a 58.6% probability of getting more than 15% per annum, which is a gain in excess of 30% for the two-year period."

Since the high end of the cap range is 40%, investors have a nearly 60% chance of generating after two years a positive return comprised between 30% and 40%.

"You have an above-average return score despite the risk, simply because you're getting paid adequately for the risk with a potential 20% annualized return. This demonstrates that a high riskmap may not necessarily damage the return score. In this case, it certainly doesn't," she said.

Price, overall

Future Value measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes scored 8.76 on the price scale compared to 7.36 for their peers.

"This is an excellent price score that shows a product that's quite aggressively priced compared to similar products. Investors are getting more value for their money. The issuer has not taken out too much in fees but instead spent a lot on the options," she said.

This result was interesting, she noted, given the uniqueness of the underlying. Typically, products that are the most common, such as S&P 500-linked notes, tend to be the most aggressively priced.

"This note is tied to a not-so-common underlying and therefore there's not as much competition compared to index-based products, for instance. When competition is fierce, pricing needs to be more aggressive. A basket of three financial stocks is an entirely different proposition than the S&P. And yet we have a high price score. That's an unexpected result and one that should be attractive to investors," she said.

"The price score may go down a bit if they choose the lower end of the cap range. But it will still end up above average."

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

At 8.24 the product scores "much better" than the 7.34 average for leverage notes recently rated, she said.

"This is an excellent overall score," she said.

"If you look at the chart plotting the riskmap against the overall score, you get the perfect illustration of a product that can score very high in terms of price and return despite the fact that it's high on the risk scale.

"This is a note designed for investors who want exposure to this specific underlying and are ready to take more risk in order to get a higher potential reward."

Bank of America Merrill Lynch will be the agent.

The notes are expected to price in January.

© 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.