BofA’s Bear Strategic Accelerated Redemption notes on Russell 2000 show different risk profile

By Emma Trincal

New York, July 24 – BofA Finance LLC’s 0% Bear Strategic Accelerated Redemption Securities due August 2021 linked to the Russell 2000 index show slightly different risk-versus-reward characteristics than typical autocallables and may be used to hedge a portfolio as a risk mitigation tool, said Tim Mortimer, managing director of Future Value Consultants.

The notes will be called automatically at par plus a premium on any quarterly valuation date after six months if the index closes at or below its initial level on the related observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The premium will be 5% to 11% on January 2021, 15.75% to 16.50% on April 2021 and 21% to 22% if called on the final observation in July 2021.

The call premium amounts will be set at pricing.

If the notes are not called, investors will lose 1% for each 1% gain in the index.

Snowball

“Bear notes are not very common. This one is interesting as it’s also an autocall,” he said.

“It comes out as a snowball, not a Phoenix autocall.”

Snowball autocallables allow investors to “catch up” with a previously missed payment when the automatic call is triggered later.

Wide range

Mortimer pointed to the six-percentage points range for the call premium on the first call date, as disclosed in the prospectus.

“Five to 11% is a wide range. But the product pricing will change over the month. Since it’s a volatile time, the issuer needs to have enough for costs and margins. The market can move quite a bit before pricing,” he explained.

Rather than offering a wider range for all the different call premium, the issuer created that wider range only for the first call, he noted.

“I think they did it that way because the first payment is what sells the product. It was also a way to solve this problem of volatility and uncertainty ahead of pricing in one shot,” he said.

Single asset

Nearly all autocallable securities bet on a flat or upward market. And most of those products have become worst-of as a result of the low volatility, he noted.

“This bearish note is tied to a single index. That’s another interesting characteristic. It’s a little different,” he said.

“They did it on the Russell, which makes sense. It’s a little bit more volatile than the S&P.

“People are worried about a pullback,” he said, adding that small-caps may be less resilient than large-caps in a recession.

“Perhaps the Russell is more exposed to a bearish situation. By linking the notes to the Russell, you can generate more premium.”

Best-of

This bearish product would have shown better terms if offered as a worst-of rather than linked to a single index, he said. But such structuring would have added a touch of complexity. The marketing of the product may have been more difficult because the product would have been harder to understand. It may also have raised regulatory concerns, he noted.

First, a standard worst-of “would not work” with this product, he said.

“Think about it. When you do a worst-of, you get a higher coupon because there is more risk in having your return tied to the worst-performer, at least when the view is range bound or bullish as it is the case 99% of the time.

“Here it would be the exact opposite. The worst-of exposure in a bear note is better for the investor who needs to see prices going down. Since it would work to your benefit, you would get a lower premium.

“So, to increase the coupon, you would have to do the reverse and make it a best-of.

“That’s a little bit weird, isn’t’ it? I think it would be hard to do. This type of structure would probably be deemed too complex or not in investors’ best interests. I think the issuer would be exposed to reputational risk, which is not helpful.”

Scorecard

Future Value Consultants offers stress testing on structured notes encompassing simulation tables as well as back-testing analysis. The report generated for this note helped explain the 22% call premium per annum, which is elevated for a single index underlier.

“You’re getting high headline terms because the two most likely outcomes are early call or downside at maturity. If the index doubles, you lose all your principal,” he said.

One of the report’s tests, called “investor scorecard,” illustrates the point. The simulation table for the scorecard displays the probabilities for several different mutually exclusive outcomes of product performance.

With this structure, the different outcomes are straightforward: call at point 1, point 2, point 3, full capital return and capital loss.

Two main outcomes

The probabilities are indeed concentrated on two outcomes.

The report shows that 44.76% of the time the call will occur during the first observation date (or “point 1”), six months after issuance.

Such outcome is favorable to investors, who receive the integrality of their principal plus the premium without incurring any further risk.

The second and the worst outcome is loss of capital. The simulation shows will happen s 39.32% of the time.

“Less than half of a chance to call at point 1 is probably reasonable. It’s in line with your typical autocall,” he said.

“Then your chances of being called decrease. That’s also quite typical.”

“The probability of capital losses if the market is up is about 40%, so it still can happen,” he said.

“In fact, it’s a pretty high probability. But you have to look at the average loss, which is only 20%. That’s a much smaller amount than usual.”

The curse of the barrier

The absence of a barrier contributed to lower the average amount of losses just as it made the event more likely to happen.

“That’s a little bit different than what we usually see in an autocall. Your average loss is lower precisely because there is no barrier,” he said.

He offered the following explanation:

When a barrier is breached, investors will lose at least the amount of the contingent protection. The lower the barrier, the greater the minimum loss. The barrier as a result tends to increase the average loss amount in stress tests. Since this note has no downside protection, the average loss is only 20%, which is typically less than most barrier autocalls.

“Capital losses can happen 40% of the time. But the average loss is 20% if you make it through that one year. Your typical autocall with a barrier reduces the probabilities of losing capital. But the tail risk tends to be higher. Losses happen less often, but when they do, they are significant.

“We’re dealing with two different risk profiles.”

Back-testing

Back-testing analysis revealed different frequencies of early calls based on the chosen time horizon as the market changed over time.

For instance, a call at point 1 happened at a frequency of approximately 32% in both the past five years and the past 15 years. But looking back over the past 10 years, the frequency of an early call dropped to 28%.

“This makes sense. Going back 15 years, you’re still catching the fall of Lehman Brothers and the financial crisis. We had a bear market at the time, which made the notes perform better, raising the probabilities of calling,” he said.

“The past five years have also been volatile with plenty of market sell-offs,” he added, pointing to December 2018 and the recent bear market in February and March.

It’s in the last 10 years that the bull market ran at its fullest. Therefore, the call at point 1 occurred with less frequency during that period, he added.

Hedging tool

Investors buying the notes could do it for two main reasons – as a hedge or to express a directional view – he concluded.

“There is market risk. If the Russell doubles, you lose 100% of principal.

“But it’s unlikely.

“Any attempt to put a barrier in it would have dampened it down.”

But perhaps and depending on the purpose for which the notes are employed, a barrier for this bear product is not as necessary as it may be for the traditional autocall.

“With this product, if you want to create a barrier, it would have to be a barrier on the upside. It’s probably not particularly useful,” he said.

“Unless investors have sold all their investments, they still sit on long positions. If the market goes up, the loss on the notes will be offset by the long exposure to the rest of the portfolio.

“You can play this note either as a hedge or to express a market view.

“A small amount of this investment alongside a long equity portfolio is not unreasonable. In such scenario, it’s actually not as risky as it seems.”

The notes will be guaranteed by Bank of America Corp.

BofA Securities, Inc. is the agent.

The notes will price in July and settle in August.

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