BofA, TD digitals on U.S. indexes offer outperformance potential in sideway market, protection

By Emma Trincal

New York, April 4 – Two issuers recently priced digital notes that may offer a booster even if the index is negative.

The notes are often called “in-the-money digitals” since the initial (“at-the-money”) price is higher than the digital call option strike price at the trade date. The setup allows investors to profit from sideway markets anywhere between the downside threshold and the digital cap.

Two deals

The first note came from BofA Finance LLC, which priced $1.94 million of 0% buffered digital return notes due May 4, 2023 linked to the Russell 2000 index, the Nasdaq-100 index and the Dow Jones industrial average, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 12.4% if the worst performer finishes at or above 70% of its initial level. Otherwise, investors will lose 1% for every 1% decline of the lesser-performing index.

Toronto-Dominion Bank priced the second deal for $13.61 million with a comparable tenor of 14 months.

The digital index-linked notes provide single-asset exposure to the S&P 500 index and a 15% geared buffer with a 1.1765 multiple. The digital payout of 8.11% is triggered at the 85% level.

Buffer versus barrier

Carl Kunhardt, wealth adviser at Quest Capital Management said he preferred the second note over the first one.

“I like the fact that I’m locking in 8% whether the market is up or down as long as it’s not down more than 15%,” he said.

“We’re taking market risk-off to a certain point.”

Kunhardt said he eliminated the first deal because of the underlying and the quality of the protection.

“I just don’t like worst-of at all. And I’d rather have a buffer even with gearing. Once you breach the barrier, you’re toast.”

Another key difference between the two notes was the size of the payout.

Defense first

“You’re going to get a much higher return with a worst-of. But I still prefer the single index with 8%,” he said.

This tradeoff has its limits, he admitted.

“We’re falling into a gray area. For a moderate to moderately aggressive investor, the 15% buffer is attractive but the fact that you’re capping your upside at 8% is not.

“On the other hand, the reason I use structured notes versus holding a position long is because risk management is a bigger driver of decisions than returns.”

For the barrier note holders, a 30.01% decline in the underlying would generate a crushing loss, he said.

“With the barrier, if I’m down 30.01%, I lose 30.01%. With the buffer, I’m only down 17.66%. Big difference.”

Kunhardt has a rule, which consists of eliminating products with complex terms. Geared buffers, in his view, fall into that category as investors need to understand the impact of the multiple, which potentially can bring the value of the note down to zero.

“There’s some explaining to do if you don’t want to breach your fiduciary duty. So, if I pick the geared buffer deal, I’m already fidgeting with my rule. But I would still do it,” he said.

Range bound view

The notes also fit with this adviser’s market view.

“While I’m optimistic that we might finish the year positively, I’m not that optimistic that the market is going to be over 8%,” he said.

“If the market is up 3% and I can show 8% to the client, I’m a hero.

“If it’s down 10% and I can show +8%, I’m a hero.

“If the market is down 20% and I can show that I’m down not even 6%, I’m a hero.

“If your outlook is range-bound, this is a great note. I would do it.”

Fees, cap

In contrast, another adviser said he liked the BofA offering better.

“You can outperform quite well with the buffered note. But you have to have pretty low expectations with an 8% return over 14 months,” he said.

“Also, the fee on the TD one looks high,” he added.

TD charges a 1.09% commission for the 14-month notes versus 0.25% for BofA’s13-month deal.

“If you really think the market isn’t going to do much, then take the 8% with the buffer. But personally, I need to see at least 10% when I take equity risk,” he said.

Looking at 14-month rolling periods over several decades, this adviser found that the S&P 500 index fell within the -15% to +8% range one-third of the time. On the other hand, the frequency at which the index fell more than 15% was only 8%.

“The buffered note is pretty defensive. You’re down 16% and you only lose 1.17%. But the 8% return sort of rubs me the wrong way,” he said.

History as a guide

In contrast, the first deal showed much better terms, according to this adviser.

“First the digital strike is so much lower. You can be down 30% and still get paid and you’re getting paid a lot more,” he said.

In addition, he found that the odds of a more than 30% index decline were “extremely slim,” based on his back testing analysis.

“I have the probabilities per index. Now it’s hard to quantify the risk when you’re dealing with a worst-of. But if you set that risk aside and stick with the S&P, the odds are pretty good,” he said.

The barrier was breached over 14-month rolling periods only 2% of the time over the past 72 years. Fifty percent of the time, the S&P 500 index would fall within the outperformance range of the notes from -30% to +12.4%.

This gave investors a 98% chance of getting paid, he concluded from his analysis.

“48% of the time, you’ll leave money on the table. But you do get your 12.4%.

“Worst-case scenario: you have a 2% chance of getting your head handed to you.

“But 50% of the time, you’re going to outperform.”

He determined that the risk-adjusted return was more attractive with this note than with the other.

“You’re taking less chances of having an enormous loss with the TD one. And your risk is much easier to define since it’s not a worst-of. But I still would go for the first one.

“If you think the market will be down more than 30% in 13 months, you’re sort of betting on Armageddon. I’m going to go with the statistics. The odds of such a big decline are not that great. And you have a huge range to potentially score an enormous outperformance.”

The BofA notes are guaranteed by Bank of America Corp. and BofA Securities, Inc.is the selling agent.

The notes settled on Thursday.

The Cusip number is 09709UJ25.

TD Securities (USA) LLC is the agent for the $13.61 million offering.

The notes will settle on Wednesday.

The Cusip number is 89114VAH0.

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