BofA’s leveraged notes on S&P/TSX 60 to use rare underlier, unusual currency conversion

By Emma Trincal

New York, May 30 – BofA Finance LLC’s 18- to 21-month leveraged notes linked to the performance of the U.S. dollar value of the S&P/TSX 60 index present two unusual characteristics, according to sources and to data compiled by Prospect News.

First, the issuer is using a relatively uncommon underlying benchmark.

Second, the payout will be based on the index’ return converted in U.S. dollars, which exposes investors to currency risk unlike most structured notes on foreign indexes, which hedge such risk.

If the index return is positive, the payout at maturity will be par plus 3 times the index gain, capped at 19.53% to 22.95%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is zero or negative, the payout will be par plus the index return with full exposure to losses.

Rarely used

The S&P/TSX 60 index tracks the large-cap market segment of the Canadian equity market. The acronym TSX stands for Toronto Stock Exchange.

As a sole underlier, the S&P/TSX 60 index has only been used in seven structured notes deals totaling $55 million since 2005, according to data compiled by Prospect News.

Records for equity index products in Prospect News’ database go back to June 2005.

The largest of those deals was priced by UBS on the behalf of HSBC USA, Inc. for $21.75 million in August 2014.

The following month, this agent priced two other deals for the British issuer, the largest one at $10.48 million.

Lehman Brothers Holdings, Inc. was the first to price a deal on this underlying with a $7.73 million offering in January 2006, according to the data. The other deals were at or less than $5 million. Royal Bank of Canada priced one of them in 2016. Morgan Stanley and Credit Suisse AG, London Branch each did one in 2014.

Commodities proxy

“This looks like some kind of indirect play on commodities,” said Matt Rosenberg, sales trader at Halo Investing.

“The TSX has a heavy exposure in commodities. As people anticipate a continued growth in the sector, with the threat of inflation rising, it’s a great way to be bullish on oil and commodities in general.”

The second largest sector in the S&P/TSX 60 index is energy with a 20.5% weighting after financials with a 39.9% weighting, according to S&P Global Ratings’ website.

Earlier this month, Goldman Sachs in a note to clients made the bullish case for commodities recommending large allocations to the asset class, he noted.

The S&P GSCI index, the benchmark for commodities, has gained 8.25% this year while the S&P 500 index is flat.

Research-driven

Other firms are starting to be bullish on commodities too, he said.

“This deal has to be related to a thesis coming from the bank. Very often big banks offer notes that can tie into their research.”

Rosenberg, despite the unusual elements of the note, including the dollar conversion, said that he believes the product will go directly to retail.

“If it was for us, it would be a reverse inquiry, an institutional deal with the objective to capture a specific type of return. But since it’s a wirehouse, private bank offering, my guts tell me it must align with their equity research,” he said.

BofA Merrill Lynch is the agent for the deal.

Dollar conversion

Another unusual feature of the notes is the absence of any currency hedge.

The U.S. dollar value of the index will be determined by multiplying the index closing level by the U.S. dollar/Canadian dollar exchange rate at maturity, according to the prospectus.

The exchange rate is the number of U.S. dollars required to purchase one Canadian dollar. The exchange rate declines when it takes fewer U.S. dollars to purchase one Canadian dollar, which means that the U.S. dollar has appreciated against the foreign currency.

Such strengthening of the U.S. dollar will negatively impact the return on the notes, the prospectus warned.

No FX hedge

“This dollar conversion is very unusual,” a market participant said.

“Most retail products do quanto; it’s easier that way.”

Structured products are priced in as “quanto U.S. dollar.” This means U.S. investors have exposure to the underlying asset class without any currency risk. To quanto an option means to hedge out the currency risk, he explained.

“With these notes, if the dollar goes up it’s not good for you. You may make money from the index performance, but you may lose part of it if the U.S. dollar appreciates.

“Say the index is up 10% but the U.S. dollar is up 20%. You’re down 10% because the exchange rate cuts your gains in half.

“Now let’s say the index is up 10% and the U.S. dollar is down 20%. You’re up even more. You’re up 30%.”

He used these simplified examples assuming a delta one payout.

“You’re not currency neutral. You can either make or lose money depending on the exchange rate.”

“These are the terms of the notes. I’m not really sure why they’re doing it. But that’s what it does: it mimics a U.S. investor buying Canadian stocks.”

The notes are guaranteed by Bank of America Corp.

The Cusip number is 09709TER8.

© 2015 Prospect News.
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