Bank of America's one-year Stars on S&P 500: high potential gains, modest risk, analyst says

By Emma Trincal

New York, June 11 - Bank of America Corp.'s upcoming one-year Strategic Accelerated Redemption Securities linked to the S&P 500 index offer a "good risk-reward trade-off for mildly bullish investors who want some level of downside protection," said Tim Mortimer, managing director at Future Value Consultants.

Bank of America is planning to price this month or in July 0% Stars due in June 2011 or July 2011, according to an FWP filing with the Securities and Exchange Commission.

If the index closes at or above its initial level on any of three semiannual observation dates, the notes will be called at par of $10 plus a premium of 9% to 13% per year. The exact premium will be set at pricing.

If the notes are not called, the payout at maturity will be par if the final index level is greater than or equal to the threshold level, 90% of the initial level. Investors will be exposed to any decline below the threshold level.

"If at any of the three observation dates the S&P 500 ends above the starting level, you get an annualized return of 9% to 13%, and the buffer is 10%," said Mortimer. "This is a pretty high return."

Mildly bullish

"This should appeal to investors mildly bullish on the S&P. You just have to believe that the market will go up a little bit. It's also for investors who want some downside protection," Mortimer added.

Mortimer noted that the terms were still preliminary and that the 9% to 13% range for the coupon was "quite wide." While the low end of the range would still constitute an "attractive" return, Mortimer pointed to a difference between U.S. and U.K. practices in terms of pricing.

"It's quite a wide range from 9% to 13%. In the U.K., the terms are fixed, the bank takes the risk. In the U.S., the terms are set at pricing," he said.

Reduced risk

But Mortimer said that the deal offers high potential income with limited risk due to two factors - the buffer size and the autocallable schedule.

"The risk is not too high because you have three observation dates for the kick-out and a 10% buffer," he said.

The three observation dates will be scheduled for six months after pricing, nine months after pricing and at maturity, according to the preliminary term sheet.

Mortimer said that a 10% buffer is "not bad" for notes linked to an index. "A 10% buffer may be small on a single stock or a more volatile underlying. But it's decent on the S&P 500," he said.

Comparative buffers

A few examples illustrate that Bank of America has recently been offering similar deals with smaller or no buffers.

In March, Bank of America announced Stars linked to the S&P 500 with three semiannual observation dates. They had a two-year term with a call premium of 7% to 11%. The buffer for that deal was 5%, according to an FWP filing.

Last month, Bank of America priced $41.03 million of Stars due June 6, 2011 linked to the S&P 500 with a 15.28% call premium. They also had a 5% buffer.

Also last month, the same issuer sold $12.25 million of Stars due Nov. 29, 2010 linked to the S&P 500. The six-month notes had a 10.96% call premium but no buffer, leaving investors exposed to any losses.

"In general, with a reverse convertible or growth product, if you had to get a product with a 9% coupon linked to the S&P, you'd have to have much more downside risk," said Mortimer.

"With these notes, if the market is down 20%, the buffer would take care of half of it. You would only lose 10%. It's a pretty good buffer for a broad index," he said.

Finally, the index only has to be up from the initial value on those three dates for the investor to get the return, Mortimer said.

In other autocallable deals, the index needs to reach a certain threshold above par in order for the call to occur. But such is not the case with this structure, he noted.

"I think you have here the combination of a decent return potential and a pretty good buffer for an index deal," said Mortimer.

High potential gains

Future Value Consultants estimated in its report that the return for the investor if the call occurred after six months would be 4.5% to 6.5%. Investors would earn a 6.75% to 9.75% return after nine months and 9% to 13% after the end of the one-year term.

The probability table of product return outcomes published in the report reflects the fact that the notes "give investors an excellent upside potential with some downside protection," said Mortimer. Investors have a 74.7% chance of earning an annualized return comprised between 10% and 15%. In contrast, their chance of losing 5% or more of their principal is only 18.1%, according to the report. These probabilities reflect the low risk score, said Mortimer. Future Value Consultants with its riskmap measures the risk associated with a product on a scale of zero to 10. The notes carry a low 2.75 riskmap, Mortimer said.

Average return score

In order to measure the risk-adjusted return of the notes it rates, Future Value Consultants offers a return rating, which establishes the score on a scale of zero to 10. It is calculated from Monte Carlo simulations that are also collected into the probability buckets.

Although the risk of the notes is limited and the probabilities of gains are high, the return rating of 5.06 may look slightly disappointing, Mortimer said.

"I think that it's because while you only have 18% chances of losing more than 5% of your principal, if you do lose, chances are that your losses will be substantial," he said.

"It's probably dragging down the returns. However, the return rating is a reasonable score compared to other products. It is above average. You still have chances of making decent returns at a moderate risk," he said.

High value and simplicity

The notes also score high on value.

Value rating, on a scale of zero to 10, is Future Value Consultants' measure of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

The notes carry a 9.87 value score.

"This is very high," said Mortimer. "The fair value of the assets investors are purchasing is good."

Finally, the structure itself ranks high on the simplicity scale with an 8.50 simplicity rating, a score that measures from zero to 10 how easily understandable a structure is.

Good grade

The combination of a fair return rating, a strong value score and a high simplicity rating gives these notes a high overall rating of 7.57.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and risk-return profile. It's an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

Merrill Lynch, Pierce, Fenner & Smith Inc. and First Republic Securities Co., LLC are the underwriters.

© 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.