BofA Finance’s $6.24 million Accelerated Return Notes on Defense ETF not ‘defensive’ enough

By Emma Trincal

New York, Sept. 1 – BofA Finance LLC’s $6.24 million of 0% Accelerated Return Notes due Oct. 25, 2024 linked to the iShares U.S. Aerospace & Defense ETF may be a timely play in a global environment seeing rising geopolitical tensions. But the lack of any downside protection was a deal-breaker for Clemens Kownatzki, finance professor at Pepperdine University.

The payout at maturity will be par of $10 plus triple any ETF gain, subject to a maximum payout of par plus 15.9%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be exposed to any ETF decline.

War without rally

“When the pandemic started to spread in March 2020, the share price of this ETF dropped dramatically. Of course, the value of all assets fell at the same time. It was a massive crash. But the defense sector was hit particularly hard,” said Clemens Kownatzki, finance professor at Pepperdine University.

The share price of the iShares ETF plummeted by 53% from mid-February to March 23 at the onset of the Covid-19 pandemic.

“With the fiscal stimulus package at the end of March 2020, the ETF price recovered like the rest of the market.”

Less predictable was the sector’s lack of reaction to the Russian invasion of Ukraine a year later, he said.

“When the war began in February 2022, defense stocks didn’t really rally as you would have expected,” he said.

“You would think conglomerates like RTX or Lockheed Martin would profit from the war. As global defense contractors, they’re in a perfect position to gain from the U.S. government support to Ukraine.

“Even European countries started to spend more on defense due to Ukraine. So, it’s a little bit odd to see the price of the U.S. Aerospace & Defense fund sort of stuck in a range since the beginning of the war.”

RTX Corp., formerly known as Raytheon Technologies Corp., and Lockheed Martin Corp. are two leading American multinational defense contractors. They’re the ETF’s second and third largest holdings, respectively.

Sideways

“There is still a bullish case to be made on defense and aerospace stocks of course. I can definitely see the rationale behind the notes. Even if the price doesn’t move all that much, the three-times leverage can quickly get you to the maximum return,” he said.

On a 14-month period, a 15.9% maximum return is the equivalent of 13.5% per annum on a compounded basis.

“You don’t even have to be very bullish. With that much leverage, you can maximize your return even if the price goes up only a little bit,” he said.

In fact, a rise of the share price by 4.53% a year would be enough to bring noteholders to the cap.

“It’s as if this structure would work best in a range-bound or slightly bullish market,” he said.

“It’s not ideal if you’re very bullish due to the cap.

“It definitely doesn’t work at all in a bear market. My issue with this note is the lack of downside protection.”

Some of the ETF’s characteristics also raised concerns.

Poor diversification

One risk factor in particular was the excessive concentration of a few top names among the 34 holdings.

“The top two big names, Boeing and RTX, if you put them together have a 37% weight. That’s not what you would qualify as a diversified portfolio,” he said.

He also noted that RTX and Lockheed, the two defense titans, have combined a 25% weighting.

The top 10 constituents (or 30% of the fund) accounted for 75% of the market capitalization, he added.

“Concentration risk should be a red flag,” he said.

He suggested instead putting together a portfolio of defense stocks.

“You could pick a few names that exhibit a low correlation to one another, names that you’re comfortable with. It may be a better fit if you want to diversify your exposure to the sector.”

No peace in sight

Another “risk,” while difficult to imagine at the moment, could be the easing of geopolitical tensions or even peace.

“If the war between Russia and Ukraine comes to a halt, the stocks of some of those mega defense multinationals could be plunging,” he said.

But Kownatzki downplayed such scenario.

“It may take a long time before the two parties can reach an agreement to stop the fight if they do. Meanwhile, governments in the U.S. and Europe will continue to increase defense spending.”

Those expenditures could intensify on a separate front as tensions between China and Taiwan are growing.

Protection, a must

“There are many reasons to be bullish on defense stocks. But it doesn’t alleviate my concerns about potential losses,” he said.

The note was not “defensive” enough, he quipped.

“Whenever your upside is cut, the risk on the downside should also be cut.

“I understand that you’re giving up the protection for the enhanced return. Three times is a lot of leverage. But my preference would be to have a barrier or a buffer.”

Different terms

Since the pricing of protection could be a challenge for issuers given the short tenor and low volatility in the market, Kownatzki said he would not object to a longer maturity.

“I would be more comfortable with a three-year note with protection than a 14-month without it.”

For a more aggressively bullish investor, one option would be to reduce the leverage multiple and raise the cap.

“If it’s doable, I could live with two-times on the upside, a 20% buffer and extend the term to a two or three year,” he said.

The rationale for getting exposure to the defense industry is totally justified in the current geopolitical environment, he said.

“But having limited upside and unlimited downside doesn’t seem like a good risk-reward to me no matter how short the duration of your note is and how much leverage you have.

“The structure should be modified so the note is less likely to hurt your bottom-line,” he said.

The notes are guaranteed by Bank of America Corp.

BofA Securities, Inc. is the underwriter.

The notes settled on Thursday.

The Cusip is 06054E879.

The fee is 1.75%.

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