Bank of America's 10% STEP Income Securities on U.S. Steel for income seekers and bulls

By Emma Trincal

New York, May 18 - Bank of America Corp.'s $33.61 million of 10% STEP Income Securities due May 27, 2011 linked to the common stock of United States Steel Corp. may appeal to investors bullish on the stock seeking both income and potential upside, sources said.

"Investors buying these notes would have to be bullish on U.S. Steel," said Richard Sparks, senior equities analyst at Schaeffer's Investment Research, Inc.

Investors receive interest quarterly.

If the final share price of United States Steel stock is greater than or equal to the step level, the payout at maturity will be par of $10 plus 12.05%. The step level is 110% of the initial share price.

If the final share price is greater than or equal to the threshold price, which is 92.5% of the initial share price, but less than the step level, the payout will be par.

Investors will share in any decline beyond the threshold price.

Up 10%

"This must be purchased by someone who would believe that U.S. Steel has the possibility of being up by 10% a year from now but who doesn't believe that it will drop by more than 8% in that timeframe," said Sparks.

Sparks said that he liked the underlying stock, even if the structure remained somewhat risky.

"U.S. Steel has done very similarly to the overall market since its low in March 2009 as it's been on the uptrend. Like most commodity-like names or steel stocks, U.S. Steel is very sensitive to the overall market. To buy these notes, you need to believe that U.S. stocks will continue to rally within the next 12 months. We do," he said.

The technical analysis of the stock was positive, Sparks added.

"From a chart standpoint, the stock is about 75% lower than its all-time high of June 2008. And since its recent low of March 2009, it has already tripled. We do see upside potential for this name," he said.

From a sector standpoint, Sparks said that the outlook for U.S. steel producers was encouraging as they had been able to "raise their prices and pass on these raises to their customers."

Income and payout

The existence of a coupon payable quarterly at the rate of 10% for the year is also a factor that made the structure popular among investors and helped explain the large size of the offering, sources said.

But it is the prospect of earning an additional 12.05% at maturity if the stock ends up 10% higher than its initial level that motivated investors bullish on the stock, sources said.

Limited upside

While the deal offered some downside protection through the threshold value, sources said that the structure remained risky.

According to the term sheet, returns are limited to the 12.05% payout at maturity if the stock ends up 10% higher than its initial value. Investors do not participate in the growth of the underlying stock.

"Your return, if any, is limited to the return represented by the periodic interest payments over the term of the notes and the step payment, if any," the term sheet said.

Final valuation

Sparks said that the point-to-point evaluation of the stock performance reduced the odds of earning the step payment for the investors.

"If the structure said that you get your payout at maturity as long as the stock hits the step any time during the term, that would be one thing. But looking only at the final value and comparing it to the initial price makes it more like a gamble," Sparks said.

"In a year it could trade down to $20 or up to $150. I do believe that it's possible for the stock to be up at one point, someday over the next 12 months. But when you make your bet for a certain day, it reduces the probability," he said.

Bank hedging

The bank has its own risk, which it has to hedge, he added.

"For the issuer, the risk is the step level. They may hedge that by buying a call on the stock with a strike price of 10% above the initial price," he said.

But Sparks said that there were not May 2011 calls on U.S. Steel stock available right now.

"The May 2011 contracts will not be available until January or February. At that point, the bank should be able to buy calls on U.S. Steel with a May 2011 expiration date and potentially use it to hedge the risk. They will also have a better idea of what the stock is doing. The cost of the option will depend on a series of factors such as the price of the stock or its volatility," he said.

Stock versus index

Another aspect of the structure that represents risk for some investors is the choice of the underlying.

Chris Cordaro, chief investment officer at RegentAtlantic Capital, said that he is more comfortable with equity indexes rather than single stocks for those types of products.

"A single stock has so much more volatility than an index. In general, it could be easily twice more volatile," said Cordaro.

"I'd rather deal with a more diversified exposure for those types of notes. We tend to prefer an overall index. To use a single stock is more speculative than an overall index."

Shares of U.S. Steel fell by 5.22% on Tuesday to $48.48 (NYSE: X). The S&P 500 index was down 1.42%.

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

The fees are 1.75%.

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