Bank of America's $29.96 million STEP notes on Schlumberger for income-seekers, with risk

By Emma Trincal

New York, April 13 - Bank of America Corp.'s $29.96 million sale of 9% STEP Income Securities due April 21, 2011 based on Schlumberger Ltd. shares target income-seeking investors willing to take some risk with a single-stock underlier, sources said.

The security, which presents some of the traits of an autocallable, is in reality more similar to a reverse convertible type of structure, sources noted.

The notes pay the coupon quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

If Schlumberger stock finishes at or above the step level - 109% of the initial share price - the payout at maturity will be par of $10 plus a step payment of 4.15%.

If Schlumberger stock finishes at or above the initial share price but below the step level, the payout will be par. Investors will be exposed to any losses.

A 13.5% cap

The prospectus warns investors that they can lose some or all of their principal if the final share price ends up lower than the initial price.

At the same time, sources pointed to the fact that returns are capped. Investors may not expect to earn more than a 13.5% annual return, which is the sum of the coupon plus the step payment, if any.

"It pays 9% per annum and a potential 4.5% step payment if the underlying is above 109%. So it works for investors who are looking for income, willing to take risk on Schlumberger and don't think it will go above 113.15%, which is the maximum return," said Jakob Bronebakk, a structurer and associate partner at Jubilee Financial Products.

Hybrid structure

Because the 4.5% step payment is triggered on a conditional basis - when the stock rise by 9% - the structure at first appears to mimic some of the traits of an autocallable note, which would pay automatically a certain coupon once the call price is triggered.

But Bronebakk said that the differences with an autocallable were stronger than the similarities.

The notes are not de facto callable and therefore may not be redeemed early. In addition, the 9% coupon is paid independently of the performance of the underlying stock price and in addition to the step payment, if any.

"This is actually a reverse convertible with an additional 'bonus' payment if the underlying performs well," said Bronebakk.

"The lack of early redemption feature isn't an issue since it's only a year-long product. I am not sure if 9% is competitive for a reverse convertible. However, the comparison with a reverse convertible is not straightforward given the potential extra 4.15%," he said.

Looking at the volatility of the underlying stock, often cited as a risk factor with reverse convertibles, Bronebakk added that Schlumberger was a "relatively" but not excessively volatile stock.

For Chris Cordaro, chief investment officer at RegentAtlantic Capital LLC, the risk involved with these notes does not necessarily come from the structure itself or even from the stock's volatility but rather from the fact that the underlying consists of only one security.

Comparing the structure to a straight reverse convertible deal, Cordero said, "It's just slicing the risk differently. With an autocallable, you've got the potential for a quick windfall. With this, you've got to wait for the end of the term. It depends on how you want to take the risk."

Cap and buffer

Although the notes do not provide any downside protection mechanism, Cordero said that the coupon played the equivalent role of a buffer.

In addition, the structure presents a cap as well as some form of leverage-like return, he said.

"You do have a 9% downside protection. Your 9% interest is like a 9% buffer. But then, you're giving up anything above 13.5%," he said.

"So it's like having a 9% downside protection and a 13.5% cap on the upside with a little bit of leverage because if the stock goes up by 1% or 2%, you're still getting 9%. But again you have to give up a lot of the upside for that," he said.

Cordero said that his main objection to these notes is the fact that they are tied to one stock only.

"For us, this deal may have been more interesting if it was linked to a broad index. Here it's just one stock. I wouldn't want to put too much in this," he said.

Single-stock risk

"Regardless of how volatile the stock is, you take the risk of something particular happening to Schlumberger. It could be bad news. We see this deal as some potential for income with not a lot of risk, but still, you are vulnerable. If the stock loses 20%, you lose a lot," Cordero said.

On the other hand, the Schlumberger stock, which has a 1.3% yield, does not pay much of a dividend. "At least you're not giving up much," said Cordero.

Still, Cordero said that his firm prefers to use index-linked notes rather than notes linked to the share price of one stock because "there is just more risk built in a single security."

"We've used structured products to gain access to a certain asset class while changing the risk/return payoff. For instance if we think the asset class will have a moderate return, then a product with upside leverage and downside protection is going to work out," said Cordero.

Merrill Lynch, Pierce, Fenner & Smith Inc. and First Republic Securities Co., LLC are the underwriters.

The notes carry a 1.75% fee.

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