Bank of America's inverse leveraged notes linked to Russell seen as good fit for mild bears

By Emma Trincal

New York, Jan. 24 - Bank of America Corp.'s 0% bear Accelerated Return Notes due August 2012 linked to the Russell 2000 index target moderately bearish investors and may offer to such investors a more efficient alternative than put options or leveraged bearish exchange-traded funds, sources said.

The payout at maturity will be par of $10 plus three times the absolute value of any index decline, subject to a maximum return of 12% to 16% that will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will lose 1% for every 1% that the index increases.

"If you're mildly bearish on the Russell, it's a good way to lever your bet," said Lee Kramer, president of Capital Management Analytics.

"You'll make money on a small decline. But your upside is capped. It's a middle-of-the-road investment," he said.

An index decline in excess of 14%, assuming a 14% cap, would cause the notes to underperform the inverse performance of the benchmark.

As a result, the notes are not designed for investors who anticipate a strong market correction six months from now, he said.

Expensive puts

The probability that the index will decline by more than 14% is 18.7%, he said, based upon the implied volatilities priced into August out-of-the-money puts on the iShares Russell 2000 index fund, which tracks the performance of the index.

"That's not insignificant. But if you see a modest decline, then you would be better off with this than with puts," he said.

Kramer said that puts on the Russell 2000 have become expensive, which may not help the investor who anticipates only a modest decline in the index.

"If you invest in the puts on the Russell, you have to see a decline in the index that exceeds the premium that you pay for the puts," he said.

"Currently, buying out-of-the-money puts on August might cost 8% to 9% of the underlying value of the index. You would need to see at least 8% to 9% of decline just to get your investment back. It's very expensive to just buy the puts outright.

"With this note, you can benefit from a 4% or 5% decline. It's a better way to lever a bearish bet as long as you're only moderately bearish."

Versus ETFs

The notes are also a better alternative to shorting the index due to the leverage factor of three, he said.

"If the index drops 5% or 10%, you're better off this way than if you short it," he said. "It's capped at 15%, but it's still a very nice return.

"And say you use an inverse leveraged ETF. If you're wrong, if the index goes up, you're leveraging up your losses. This note is only a one-for-one loss if the index goes up."

A financial adviser agreed.

"For someone who wants to make a bearish bet, it's more conservative than three-times leveraged ETFs because with the notes, you're not losing three times when the index is up as you would with an ETF. With an ETF, you lever up both your losses and your gains. It works both ways," he said.

Investors, however, need to have a very specific market view, which led sources to caution that the product is not for everyone.

For some clients

"Personally, I don't like to take those kinds of bets," the financial adviser said.

"I'm more into growth, something that gives you a 15% cushion, a 25%-30% upside and 125% to 130% participation. That's my kind of product.

"But if you have a client who wants that kind of bearish exposure, then it's safer than buying a Proshares or an equivalent. You're capped, but your timeframe is only six months. For the right investor, it's a pretty nice offering."

An example of an inverse leveraged ETF linked to the Russell 2000 index would be the Direxion Daily Small Cap Bear 3X Shares. The fund seeks 300% the inverse return of the benchmark. If for instance the index was up 10%, the ETF investor would lose 30%.

Kramer said that he would not invest in the notes because of his own market views.

But he likes the structure.

"I wouldn't buy these notes because I'm not bearish," he said.

"I am optimistic in the very near term. We've seen a lot of fears around Europe. A lot of money managers are still underinvested, and stocks have been too deeply discounted.

"But if I was slightly bearish, I would be better off with these notes than buying a put. It's cheaper."

The notes are expected to price in January and settle in February.

Bank of America Merrill Lynch is the agent.

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