Bank of America's step-up structure seen as niche deal for BRIC buyers and dollar bears

By Emma Trincal

New York, Oct. 1 - Bank of America Corp.'s recent offering of $73.9 million 95% protected step-up notes tied to BRIC currencies is an attractive structure for investors eager to find a new formula for a bearish bet against the dollar, a financial adviser said.

The notes reflect growing market anticipations that, over a period of time, a basket of equal weights BRIC currencies - Brazilian real, the Russian ruble, the Indian rupee and the Chinese yuan - will appreciate against the dollar.

Bank of America priced on Tuesday $73.9 million of zero-coupon 95% principal-protected step-up notes due Sept. 27, 2011 linked to a basket of BRIC currencies relative to the dollar, according to a 424B2 filing with the Securities and Exchange Commission.

If the underlying basket appreciates, investors get par plus the greater of the basket gain and 13.75%. Conversely, investors are subject to losses if the basket depreciates against the dollar at maturity. But since the structure offers 95% of capital protection, investors see their loss limited to 5% of their principal.

BRIC currency trend

"I've seen a lot of those products linked to BRIC currencies lately," said Scott Miller Jr., managing partner at Blue Bell Private Wealth Management.

"Sometimes it's a digital coupon only. Sometimes it's digital plus one-to-one appreciation, like this one. Sometimes it's FDIC [Federal Deposit Insurance Corporation]-protected. But all those deals are definitely related to the dollar.

"People anticipate a continued decline of the dollar. Everybody is worrying about how much the U.S. is spending. At this point, even if the dollar weakens, it may not fall much further against the euro. That's why you're seeing so much interest around those BRIC currency structures right now," said Miller.

Several U.S. banks have last month announced or priced deals referencing BRIC currencies.

HSBC USA Inc. said it would price zero-coupon 95% principal-protected notes due Sept. 9, 2011 linked to BRIC currencies, offering a leveraged structure paying out 98% of par plus at least 152% of the basket appreciation versus the dollar, subject to a 20.8% cap.

A similar deal by the same issuer with the same term and the same underlying offered a payout at maturity of 98% of par plus at least 1.29 times any basket gain, up to a maximum return of at least 17.35% per note.

Citigroup Funding Inc. also came out with a similar product last month when it said it planned to price 0% notes due 2011 also linked to the performance of a BRIC basket with a payout at maturity of 95% of approximately 25%.

Step-up flavor

But Bank of America offers a more unique twist with its step-up structure, something Miller said was more unusual, although he said that HSBC is doing "similar things." According to Prospect News data, step-up structures are not all that common lately and the use of BRIC currency as the underlying within a step-up note is even more atypical.

In Bank of America's version of a step-up note, investors get the greater of the appreciation of the underlying asset and a step-up payment paid at maturity. It allows investors to participate in market gains. The size of Bank of America's new issue - almost $74 million - suggests that the offering was well received by the market.

"I think it's a good deal but you have to compare it with other types of structures. I guess if you compare it to a CD, here you're taking some credit risk," said Miller.

"The digital coupon is a little bit higher than a CD because you have the credit risk exposure. The question is: could you do that with FDIC and be just a good? Or could you do the same note with a higher coupon? "

A sellsider in London added: "We're not seeing a lot of those step-ups in Europe. I'm not sure there are so many in the U.S. either."

Commenting on the notes, he said: "I guess you get better than Treasuries but it's linked to BRIC currencies. A lot can happen in two years," he said. The two-year Treasury yield is currently at 2%.

ETF vacuum

Miller said that exposure to BRIC currencies through structured products is almost always done via a basket referencing the four currencies, not via the pick of a single one of such currencies.

"That's because those currencies are not correlated. Putting them together in one basket is a way to give you more upside. Otherwise, the structurer may not be able to give you that payout," he said.

Sources said that the demand for BRIC currency-linked notes may fill a void given that there does not seem to be a great deal of supply of ETF products that would allow investors to gain exposure to the currencies of the four BRIC nations.

"I am only familiar with BRIC equity ETFs or ETFs specializing in one of those BRIC countries. There are a lot of gaps in ETF coverage or even countries," one source said.

Among some of the most common BRIC ETFs are the iShares MSCI BRIC and the Claymore/BNY BRIC, both of which replicate equity performance. Other ETFs, such as the Market Vectors series or iShares MSCI are also equity-based and may just cover one specific BRIC country.

To peg or not

Another source said that part of the volatility and uncertainty in BRIC currency-linked instruments lies in the unstable trade relationship between the United States and China.

Pointing out that the Bank of America notes offered an attractive upside potential, he said: "I wonder if this is not something they can do just because the yuan continues to be pegged to the dollar. If China continues to manipulate its currency in order to keep it lower than the dollar, then the yuan will not appreciate and that's 25% of the basket," he said.

He said that he was referring to Chinese's long-held policy of keeping its currency from appreciating against the dollar as a tool to give Chinese goods a trade advantage over the United States and Europe. This source said that it is hard to predict whether the yuan will remain linked to the dollar or not and whether China will opt to stay the course or change its currency policy.

"If the yuan is no longer pegged to the dollar, then investors in these notes would be in a very good position," he said, adding that in such case, the yuan's appreciation against the dollar would be significant.

Merrill Lynch, Pierce, Fenner & Smith Inc., First Republic Securities Co., LLC and Banc of America Investment Services, Inc. are the agents. The fees are 1.75%.

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