BofA, Morgan Stanley, Barclays plan oil-based bullish notes amid oil price spikes, Iraq crisis

By Emma Trincal

New York, June 19 – Issuers are preparing notes linked to oil in an effort to give bulls options to tap into the oil rally triggered by the recent conflict in Iraq, sources said.

Two notes offer unlimited upside, one in the form of a step up at maturity if its autocallable feature is not triggered and the other above a minimum return. Both structures offer some form of protection, although sources said that protection is probably not enough for the respective asset classes. One note is linked to a sector equity index while the other is directly linked to the commodity price.

“Those notes are great if you’re a bull. Right now, oil is trending up strongly given the Middle East crisis, so you’re jumping in momentum,” said Steve Doucette, financial adviser at Proctor Financial.

West Texas Intermediate light sweet crude oil, the index for U.S. crude oil and one of the notes’ underliers, has gained 4% in less than three weeks.

Bank of America

The first announced deal is Bank of America Corp.’s 0% autocallable market-linked step-up notes due June 2017 linked to the S&P Oil & Gas Exploration and Production Select Industry index.

The notes will be called at par of $10 plus a premium if the index’s closing level is greater than or equal to the initial level on either observation date. The premium will be 10% if the notes are called in June 2015 or 20% if the notes are called in June 2016, according to an FWP filing with the Securities and Exchange Commission.

If the index finishes above the step-up value, 120% of the initial value, the payout at maturity will be par plus the index return.

If the index return is zero or positive but the index finishes at or below the step-up value, the payout will be par plus the step-up payment of 20%.

Investors will receive par if the index finishes at or above the threshold level, 99% to 95% of the initial level, but below the initial level, and they will be exposed to any decline below the threshold level.

Morgan Stanley

Separately, Morgan Stanley said it will price 0% enhanced trigger jump securities due August 2015 linked to West Texas Intermediate light sweet crude oil.

If the final price of oil is at least 85% of the initial price of oil, the payout at maturity will be par plus the greater of 8.8% and the percent change in the price of oil. Otherwise, investors will be fully exposed to the decline in the price of oil, according to a 424B2 filing with the SEC.

Great for bulls

Commenting on the Bank of America deal, Doucette said the downside risk is a concern.

“Your money is tied for three years. Your protection is very limited. You could lose [nearly] your entire investment. If the price of oil is down in three years, you’re long energy. That’s what’s scary about these notes. That said, you’re not exposed to oil directly but to an equity index, which is much better,” he said.

“The index includes not just oil companies but gas producers as well, which is a plus because if one of the two falls in price, the other may rise and offset the decline.”

Still, the very restricted downside protection is a drawback in his view.

“If I was to structure the deal, I might give up some of the coupon for more protection,” he said.

“Energy has been a major driver behind commodity funds’ performance, so you might be pleasantly surprised with these notes.

“But I like to look at all possible scenarios, which include the worst-case scenario.

“It’s easy to go for these notes in order to chase the 10%, but what if you’re wrong?”

One attractive side of the structure, he noted, is the possible participation in the index growth and the fact that investors are not necessarily capped by the call premium. In fact, in the absence of an autocall event, the payout at maturity is uncapped.

“It’s a great note for a bull on energy. It’s very appealing for a bullish investor, but you have to keep in mind the downside risk,” he said.

Volatility

Looking back to the year 2011, he pointed to the price of the index, which from July to August dropped 31% in only one month.

“These are serious moves. With anything related to energy, you’re going to see volatility. Every couple of years this index drops by 15%. I see more potential for losses than there is for gains,” he said.

Analyzing the second product linked to WTI futures contracts with an 85% barrier, Doucette said that the downside risk is probably greater.

“Even though you have a 15% protection, I wouldn’t go there because there is more volatility than the stocks. It’s very short term; it looks more like gambling to me. I would lean toward the stocks. With the first deal, you have a longer stretch of time and the stocks may have good fundamentals, while the commodity price itself is unpredictable,” he said.

Investors’ market risk exposure is not only determined by the amount of protection incorporated in the structure. It is to a large degree a function of the implied volatility of the underlier, he explained.

“Clearly, I see more risk being exposed to oil directly even though I have more protection. A 15% barrier can be breached in no time with oil,” he said.

Attractive jump

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the protection level is important when deciding whether to buy a structured note or to take a long position in the asset.

“I first look at the underlying and then the buffer. If I like the underlying asset class, I’m going to seek a structure that provides me with the strategy but also the additional benefits that I wouldn’t have if I just went long the strategy,” he said.

His preference is Morgan Stanley’s trigger jump notes. The short tenor is one factor.

“In light of what’s happening in Iraq, if the resolution of this crisis is not achieved in a short period of time, the potential for energy or WTI to rise in value makes a lot of sense. In that context, I like that it’s a 13-month note that you can reassess in a short period of time. You’re not making a long-term commitment to oil. If I do an event-driven investment, I don’t want to go too far out in my allocation,” he said.

Both products are equally attractive in offering investors unlimited upside potential. But the second product makes the upside participation easier to achieve than the first one. Its “jump” feature offers the potential to receive more than par in the event of a negative performance.

“On the downside, if the crisis is resolved and prices reverse back to lower levels, I like very much the fact that as long as I’m not breaching the barrier, I’m getting a positive return,” he said about the Morgan Stanley structure.

“That’s attractive especially if oil resumes trading in a range and if the situation in Iraq improves. Based on oil’s current price and the way it’s been trading, I don’t expect we would be hitting that barrier. I can’t see any significant macroeconomic factor that would be pulling down the price of oil over the next 13 months.”

1% buffer

The Bank of America notes offer an appealing underlying, but their risk mitigation is not sufficient, he said.

“I’m interested in this S&P sector index. Exploration is good. The fact that these are mid-size companies from an energy perspective is very attractive in this market,” he said.

“But generally speaking, when I look for products, my preference is to get a buffer associated with the structure, otherwise I would be more inclined to go long the index. This one has a 1% to 5% buffer. A 1% buffer is close to nothing, especially on mid-cap companies involved in energy exploration. I have never seen a small buffer like that before.”

The S&P Oil & Gas Exploration and Production index is up 20.75% this year to date. It gained 1% on Thursday.

Barclays’ digital step up

Separately, Barclays Bank plc will price 0% digital step-up notes due Dec. 24, 2015 linked to futures contracts on West Texas Intermediate light sweet crude oil, according to a 424B2 filing with the SEC.

If oil finishes at or above the initial price, the payout at maturity will be par plus the maximum return of at least 25%.

If oil falls by up to 15%, the payout will be par plus the 12% digital return.

Otherwise, investors will be fully exposed to any losses.

“Again, these are great for bulls, but 15% protection on oil is really not that much,” Doucette said of this structure.

BofA Merrill Lynch is the underwriter for the Bank of America autocallable step-up notes, which will price in June and settle in July.

Morgan Stanley & Co. LLC is the agent for the trigger jump securities (Cusip: 61762GBU7), which will also price in June and settle in July.

Barclays is the agent for the Barclays Bank notes (Cusip: 06741UFE9), which were scheduled to price Thursday and will settle on Tuesday.

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