Bank of America's $284.49 million leveraged notes tied to Dow with 30% buffer top year so far

By Emma Trincal

New York, July 2 - Bank of America Corp.'s $284.49 million of 0% Leveraged Index Return Notes due June 29, 2018 linked to the Dow Jones industrial average was the largest offering so far this year, according to data compiled by Prospect News. The issue drew its popularity from an unusually large buffer, sources said.

The payout at maturity will be par of $10 plus 122% of any index gain. Investors will receive par if the index falls by up to 30% and will lose 1% for every 1% that it declines beyond 30%, according to a 424B2 filing with the Securities and Exchange Commission.

The final index level will be the average of the closing levels on the five trading days ending June 26, 2018.

"With this deal, you're giving up the flexibility of getting out of the market for five years. But in exchange, you're getting the downside protection. I think that's the main appeal," said Donald McCoy, financial adviser at Planners Financial Services.

Marketing efforts

A market participant said that extending maturity in exchange for more downside protection was still a relatively new trend. The size of the deal illustrated that many investors responded positively to the trade-off.

"The first time [Merrill Lynch] did those deals, they did it in small sizes. They've tested those products in the past three or four months. Now they've got financial advisers to do those longer maturity notes. They moved slowly. First they found people who would consider those products. Once they had enough people to look at those deals, they've been slowly moving to market them on a larger scale," the market participant said.

"This deal is the result of a patient marketing effort.

"You get a very good downside protection, but you still have to pay for it. You're giving up 150 basis points in credit spreads and 2% in dividends for a five-year period. But the result is that people like it. The buffer makes the deal very attractive. It was not sold to an institution. It's definitely retail."

While the downside protection was the eye-catching feature of the notes, buysiders said that it had a cost.

"It's pretty straightforward. At the end of the five years, if the index is down by less than 30%, you're back to even," McCoy said.

"On the upside, if the Dow is up 10% at maturity, you get 12%. Obviously, they don't have to give you much on the upside because they give you a significant protection on the downside."

Buffer use

McCoy said that the chance that the index will drop by more than the buffer amount is remote.

"Over the course of five years, the odds that the Dow will be lower than it is now are historically small," he said.

"If you look at the past five years, even taking into account the disaster of 2008, we've been averaging about 8% annually, even with this horrific market crash.

"The closer you get to the end of the term, the greater the risk of losing money. That's because by then, you're running out of time to recover anything. It's always a risk when you invest in long-term [notes].

"I think you're getting a pretty good protection on the downside. Given the current market conditions, I don't see the market being threatened by anything resembling 2008.

"We might have a big drop at some point. But if you're up over that timeframe, you're only giving back some of your winnings. It's unlikely that we would lose more than 30%."

Even if the 30% buffer may not even be necessary, McCoy said that it had a psychological meaning for investors worried about market downturns.

"Investors are still concerned about the downside exposure. While 2000 and 2008 are kind of fading a little bit in investors' memories, the fears are not entirely gone," he said.

"Something like this offering 30% protection is going to be attractive to people who still want to have that market exposure. It makes them feel more comfortable."

Weak economics

Steven Foldes, president and chief executive of Foldes Financial Management LLC, said that the downside protection had a cost, which he said was not worth paying for.

"I don't love the 2.5% fee, that's my first issue," he said.

"A 30% buffer is a nice downside protection, but that's a very significant amount, maybe more than what you need when you consider the muted upside.

"When we do a reverse inquiry, we get 1.5 times minimum, and most often, we get two or three times the upside ... and we never go beyond three years as it relates to these deals.

"With this one, you're tied up for five years; you're getting 30% on the downside, which is nice, but you have to pay for that as you're giving up a significant amount of upside. A 1.2 times leverage factor is not much; a 2.5% fee is pretty high. From what we do at our firm, the economics look very weak."

For Foldes, investors who bought the notes may not have realized that they were overpaying for the downside protection.

"It's the buffer that made this product so popular, but it's somewhat illusory," he said.

"A 30% downside protection on a five-year may really not be necessary. Obviously, it depends on when the decline takes place. But it worked from a marketing perspective. The idea that you can get 30% of downside protection is pretty compelling.

"In the meantime, you've given up a lot for that buffer. There are better economics available there. If I had done a reverse inquiry, I would have been underwhelmed not overwhelmed by this type of product."

The notes (Cusip: 06053F174) priced June 27.

BofA Merrill Lynch was the agent.

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