BofA, Morgan Stanley link bearish notes to S&P 500; acceleration, high caps useful for hedge, adviser says

By Kenneth Lim

Boston, March 25 - A couple of bearish accelerated notes linked to the S&P 500 index offers investors a way to seek positive returns in a down market and to hedge against existing bullish positions, an investment adviser said.

Meanwhile, market sources said issuers of exchange-traded notes under the Elements platform are expected to begin reassuring investors that they will underwrite future issues now that Merrill Lynch is no longer underwriting them.

Bank of America Corp., via agent Merrill Lynch & Co., plans to price 14-month Bear Accelerated Return Notes linked to the S&P 500.

At maturity, the notes will pay par plus five times of any decline in the index, subject to a maximum total payout of 210% to 211.4% of the principal. The exact cap will be set at pricing.

The payout will be par if the index is flat or not more than 110% of its initial value. Investors will lose 1% for every 1% that the index finishes above 110%. Investors will not lose more than their principal.

Morgan Stanley is offering Bear Market Performance Leveraged Upside Securities due Oct. 20, 2009 linked to the S&P 500.

At maturity, investors will receive par plus triple any decline in the index, subject to a maximum total payout of 211.05% to 211.45% of the principal. The exact cap will be set at pricing.

Investors will lose 1% for every 1% that the index finishes above its initial level, subject to a minimum total payout of 20% of the principal.

Tempting terms

The products offer generous headline numbers, the investment adviser said.

"Those are really high ceilings," the adviser said. "You could potentially more than double your principal in six months. The thing I would say is it's kind of double-edged. On the one hand the participation rate and the ceilings look really, really tempting. On the other hand you're getting those terms only because the products is really, really risky. The equity market's volatility is extremely high, and it's really hard to say with any degree of certainty where it's going to be in six months or two years. It's like buying a lottery ticket."

The high underlying volatility and the lack of clarity on where the markets are headed allow the longer-dated Bank of America notes to offer higher participation rates, the adviser said.

"I think it's because they're longer dated," the adviser said.

Potential hedge

Investors who are bearish on the S&P 500 will naturally find the products attractive, the adviser said.

"The upside is really high on these when you consider the participation rates and the ceilings," the adviser said. "If you wanted to be short on the S&P, these would be worth a look."

The products could also be useful for investors who have existing long positions on the underlying index, the adviser added.

"Let's say I have $100,000 long on the S&P, a straightforward direct investment, one-on-one on the upside and downside," the adviser explained.

"I can invest $20,000 on the Bank of America one, for example, and I will at least break even as long as the S&P falls. That's because of the participation rate and because the maximum payoff is so high. If the S&P goes up, I still make money because it's one-on-one on the downside in my hedged position but my base is smaller there. I could put even more in the structured note, let's say I buy $50,000, then I actually make money if the S&P goes down, and I still make a profit if it goes up, only my profit on the upside is smaller."

All of the potential returns, however, are conditional upon the issuer being able to pay at maturity, the adviser said.

"It looks great on paper, but ultimately you have to also think about the credit quality of the issuer," the adviser said. "Are you comfortable holding Bank of America or Morgan Stanley unsecured debt?"

Issuers to underwrite Elements

Issuers of exchange traded notes under the Elements platform are expected to take on the underwriting of future offerings themselves instead of through Merrill Lynch, a market source said.

The matter was highlighted recently when Deutsche Bank AG announced that it will act as underwriter on future additional issues of some Elements ETNs. Those ETNs are linked to the Morningstar Wide Moat Focus Total Return, Dow Jones High Yield Select 10 Total Return, Benjamin Graham Large Cap Value Total Return, Benjamin Graham Total Market Value Total Return and Benjamin Graham Small Cap Value Total Return indexes.

Deutsche Bank has not given any indication that its commitment to the platform has been reduced, the source said.

Other issuers who have sold Elements are Credit Suisse, HSBC USA Inc. and AB Svensk Exportkredit.

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