Bank of America's $21.56 million Mitts tied to Merrill Lynch commodity index may overprotect

By Emma Trincal

New York, Oct. 9 - Bank of America Corp.'s $21.56 million issue of 0% Market Index Target-Term Securities due Sept. 24, 2019 linked to the Merrill Lynch Commodity index eXtra - Excess Return is unusually short in duration for a fully principal-protected note, sources said.

One possible explanation and perhaps also drawback is the use of a proprietary index as the underlying, which may offer overlapping layers of protection, sources said.

The payout at maturity will be par of $10 plus any gain in the index, subject to a maximum return of 71%. If the index falls, the payout will be par, according to a 424B2 filing with the Securities and Exchange Commission.

"The structure itself is very simple. The complexity in the product comes from the underlying index," a market participant said.

Roll yield

The underlying index (Bloomberg symbol "MLCXER") is an excess return index that factors in both price movements as well as roll yields, according to the prospectus. It is a version of the Merrill Lynch Commodity index eXtra (the "MLCX").

The MLCX was designed to "extract alpha" from the forward contract curve, according to a Global Commodity Paper published by Merrill Lynch.

The rule-driven commodity index selects commodity futures contracts by liquidity and then weighted by the importance of each commodity in the global economy.

The MLCX is comprised of 12 to 22 futures contracts on physical commodities.

As the contracts approach the month before expiration, they are replaced by contracts that have later expiration dates, a process called "rolling."

Instead of rolling a basket of commodity futures contracts in a conventional front- to second-month roll schedule over a five-day window, the MLCX was designed to roll semi-continuously. The roll is over a 15-day window from a second- to third-month futures contract from the first through the fifteenth business day of the month.

According to the paper, this roll mechanism was based on research suggesting that rolling futures contracts farther out contributed to enhance roll returns significantly.

For instance, instead of rolling front-month contracts into second-month contracts, the index rolls fourth- into fifth-month contracts.

The index invests in six sectors: energy; base metals; precious metals; grains and oil seeds; livestock; and soft commodities and others.

Complexity

The market participant said that such products are too complex for the retail clients of his firm.

"We have looked at a variety of these proprietary indexes that are trying to manage volatility or in this case the futures curve to try to take advantage of the shape of the curve and lower the negative impact of the curve," he said.

"To this date we haven't been able to get comfortable offering notes on indexes like that. We are not convinced that investors have the ability to fully understand how the underlying index works and the kind of exposure they're really getting."

Round into round

The market participant offered a second objection.

"When trying to put together a principal-protected note, the issuer has to fit a square peg into a round hole. Here, they've created a round peg to fit into this round hole to give you principal protection," he said.

"The indexes themselves I think are a fine idea. It's a way to lower the risk exposure to an asset class.

"When you have a product based on those types of indexes, OK, that's fine. You've watered down the risk through the index mechanism.

"But if on top of that you're wrapping that in a principal protection, it's a little bit overkill. How much protection can you really put in a note? That's what has been going on with some of those proprietary indexes." An industry source said about the structure: "It doesn't look bad."

But he was surprised to see gold as the top allocation. It has a 4.39% weighting in the index, according to the prospectus.

"Unfortunately, with gold getting hammered and commodities down from last month, it may not be the best time to be in this asset class," he added.

"The six-year term is shorter than most principal-protected notes, although things have really changed because it used to be four to five years and it's now more like seven to 10 years."

He agreed that the use of some of the rule-based indexes explains how the term could be made shorter with full downside protection.

"These broad-based indexes, they tame the returns, and you can slam them in a shorter maturity note," he said.

The notes (Cusip: 06053F638) priced Oct. 1.

BofA Merrill Lynch was the underwriter.

The fee was 2.5%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.