Bank of America's step-up notes linked to S&P 500 offer several ways to beat the benchmark

By Emma Trincal

New York, May 11 - Bank of America Corp.'s 0% market-linked step-up notes due May 2015 linked to the S&P 500 index enable investors to outperform the index in a flat to moderately positive market as well as to participate in higher growth, said Suzi Hampson, structured products analyst at Future Value Consultants.

If the index finishes above the step-up value - 120% to 126% of the initial value - the payout at maturity will be par plus the index gain, according to an FWP filing with the Securities and Exchange Commission.

If the index gains but finishes at or below the step-up value, the payout will be par plus the step-up payment of 20% to 26%. The exact step-up amounts will be set at pricing.

Investors will receive par if the index falls by up to 15% and will lose 1% for every 1% that it declines beyond 15%.

Three features

"This note gives you the potential for a fixed return but also growth," Hampson said.

"The fixed payment part is one similarity with a reverse convertible. But the two products are very different.

"A reverse convertible gives you a fixed return regardless of the performance of the underlying. With this one though, you get the digital payout only if the index closes between the initial level and the 125% step level."

The 125% figure is derived from the formula Future Value Consultants uses when determining a hypothetical value from a range: it chooses a level at 75% within the range.

"You have three attractive components in this structure: the step-up, the uncapped return on top of that and the buffer," she said.

"If the index finishes between 100% and 125% [of the initial level], it's a modest growth scenario with 8% per annum. In this case, your return will be enhanced with the digital and you will outperform the index."

The product can also deliver unlimited upside because it is uncapped, a feature that, combined with the digital payout, makes the terms particularly attractive to bullish investors, said Hampson.

"It's not just the digital. You can also participate in the growth of the index. Any growth above the 125% level is a bonus.

"Finally, the 15% downside protection buffers your losses. You also outperform on the way down."

Hampson explained that in return for those positive terms, investors have to assume Bank of America's credit risk and give up dividends over a three-year period.

"It's a three-year, and it's a little bit longer than similar products. That's why the terms look better. That's how the product is funded," she said.

Similar products sold by Bank of America may have a shorter duration - of two years, for instance - but they will have lower step-up values and/or no downside protection, according to data compiled by Prospect News.

Hampson said that the optimal market environment for the step-up note is high growth as opposed to a reverse convertible, which would require a low-volatility market.

"This is for a bullish investor, and you will outperform in a moderate-growth environment. However, given that there's no cap, everything over the step-up is for you to take. So you really want as much growth as possible," she said.

"High growth is ideal for any uncapped upside. This is the case here. You can go above 125%. You're not cutting off any further growth."

Future Value Consultants calculates its scores based on the most favorable market assumption for any given product. As a result, the scores for this note are derived from the high-growth assumption, she said.

To calculate its score, Future Value Consultants compared the notes to all products - or the average of all products recently rated by the research firm. Scores were also measured against the "same product type" category, which in this case means digital notes. Those products offer a conditional fixed return when the underlying performance reaches a certain threshold.

Lower market risk

Riskmap is a Future Value Consultants rating that measures the risk associated with a product on a scale of zero to 10. The higher the riskmap, the higher the risk of the product.

The riskmap of the product, 4.42, is average compared to all products (4.35) and similar products (4.26).

But the riskmap is the sum of two components: the market riskmap and the credit riskmap. With these notes, the market riskmap is lower than average and the credit risk is higher, Hampson observed.

"The market risk is lower than the average because a lot of these products don't have buffers. They may just have barriers or just nothing," said Hampson.

"But the credit risk is higher than average because this product is a little bit longer than the normal."

Risk-adjusted return

Compared to all products, the notes have an above-average return score, which is Future Value Consultants' measure of the risk-adjusted return of a product. The rating is calculated using the 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, which for this note is high growth.

The 7.55 return score of the product exceeds the 6.47 average of all products. This good score is a result of a reduced downside risk and high potential returns, she said.

"The loss of capital is reduced because of the buffer. The high-growth scenario on a three-year duration gives you a greater chance of a higher return. Finally, your return is uncapped. These are all factors that explain the high return score," Hampson said.

Price, overall

The price score on a scale of zero to 10 measures the value of a product to the investor. The more the issuer spends on the options, the more value it provides to the investor.

With a price score of 6.47, the notes are below the average of the same product type at 7.55.

"Of all the three scores, the price score is the one that underperforms," said Hampson.

"It could be a case of 'wait and see' until it's priced since we don't have an exact step-up level. They may very well price at the top of the range. Of all the scores, the price score is the one that's the most likely to move," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

The overall score for those notes is 7.01. It is less than the average score of similar products at 7.39. On the other hand, it is better than the 6.71 average rating for all products, she noted.

"It's still a good overall score. It's been dragged down by the price score, but the overall is still higher than the average product," she said

Bank of America Merrill Lynch is the agent.

The notes are expected to price in May and settle in June.

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