Bank of America's five-year protected Mitts on Dow Industrials is competitive, analyst says

By Emma Trincal

New York Aug. 13 - Bank of America Corp.'s planned 0% Market Index Target-Term Securities due September 2015 based on the performance of the Dow Jones Industrial Average "compares well to equivalent principal-protected products," said Suzi Hampson, structured products analyst at Future Value Consultants.

The choice of the Dow Industrial as the underlying and the five-year term allowed the issuer to offer attractive terms, she said. Yet, investors should keep in mind that they are still subject to the issuer's credit risk and that the relatively attractive terms do not guarantee a better performance, she said.

The payout at maturity will be par of $10.00 plus any index gain, up to a maximum payout of $14.00 to $15.00 per note, according to a 424B2 filing with the Securities and Exchange Commission, with the exact cap to be set at pricing.

If the index falls, the payout will be par.

Hampson said that the notes are for investors who want exposure to the market but with low risk. In order to get the principal protection, these investors are willing to see their returns capped at 40% to 50%, which is not more than 10% annually.

Option cost

Principal protection deals are rarer than before due to the low interest rates environment, which does not support the economics of these products, she said.

Principal-protected products issued in the United States account for only 2% of the total issuance volume to date, according to data compiled by Prospect News.

Structuring a principal-protected product requires combining a zero-coupon bond that will mature at par and buying a call option, she said. The issuer buys the call option with the difference between the notional and the cost of the zero. When interest rates are low, the cost of the bond is greater. Therefore buying the call option at the cheapest possible level is one way to make those deals more attractive, she said.

Less volatility

Hampson said that the implied volatility of the Dow Jones Industrial Average was 23%, less than the volatility of the S&P 500 at 26%.

"With a principal-protected note, an underlying with less volatility is more attractive as it reduces the cost of the option," Hampson said.

She explained that with more volatile underlyings, the cost of the option will be more, which limits the issuer's possibilities to offer attractive terms. For instance, in such cases, they may have to lower the cap or extend the maturity of their products, she said.

In other cases - much rarer in the United States than in the United Kingdom, she said - the issuer will offer a participation rate of less than 100%, for instance 80%. "This does not make the deal very appealing," she said.

But with the underlying used in this product, the lower cost of the option enables the issuer to make the product more attractive, introducing for instance a relatively appealing cap and a maturity that tends to be shorter than equivalent notes, she said.

Many recent principal-protected notes are based on the S&P 500 index or a combination of the S&P 500 and a basket of exchange-traded funds, according to data compiled by Prospect News.

"The Dow Jones Industrial is not very often used in principal-protected products," said Hampson. "But we're seeing more of it recently. I expect this index to be used more often as it's less volatile at the moment."

Return probabilities

Future Value Consultants publishes a chart that displays probabilities of returns. The chart shows different return buckets from losses to gains with a probability assigned for each of those.

Investors in this deal have 52.2% chances of scoring a 0% to 5% return while the odds of generating a gain comprised between 5% and 10% are only 47.5%.

The probability of incurring a loss is null given the principal protection with the credit risk not being factored into the model.

Hampson explained that the probability is higher for the bucket of zero to 5% returns because it would include all situations where the return would be zero.

The firm's methodology assembles in the same bucket a 0% return and positive returns greater than zero but lower than 5%. Because of this lack of breakdown, it is not possible to distinguish a situation with no gains and no loss from an outcome of small gains under 5%, Hampson said.

The product offers an attractive risk-return profile, Hampson said.

The return rating is Future Value Consultants' indicator, on a scale of zero to 10, of the risk-adjusted return of the notes. It is calculated from a Monte Carlo simulation that takes into account a series of parameters, which include for instance among others, volatility, dividends and interest rates.

The deal has a 5.85% return rating.

"It's above average. The average is below 5," Hampson said.

High overall

The product is also characterized by a good overall rating of 8.02, Hampson said.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and risk-return profile. It's an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

The value rating measures from 0 to 10 how much money the issuer spent directly on the assets versus fees and profit margins. This product has a 9.70 value rating, which is "high," Hampson said. She added that it may be related to the maturity of the deal, longer than non-principal-protected notes. "The longer term products tend to have a better value score," she said.

The simplicity of the structure is also well rated. Its score is 9.70 on a scale of zero to 10.

"An overall of 8.02 compares quite well with other rated products," she said. "The highest of the currently principal-protected notes we've rated was 8.07. But it's usually in the 7's."

Low risk

Another aspect of the deal is its low risk of 1.77 as measured by riskmap, a Future Value Consultants rating that measures the risk associated with a product on a scale from zero to 10.

"The 1.77 riskmap is all credit risk," said Hampson.

She said that investors get their principal back at maturity subject to the bank's credit risk, which is factored into the riskmap.

A mitigating factor of the risk is the five-year term, Hampson said.

"The shorter the term, the less credit risk there is," she noted.

"I haven't seen any principal-protected notes shorter than five-year, so this is a relatively short maturity for this type of structure," she said.

Overall, this product "compares well" to others in the market, she said.

"It could be that the underlying is less volatile, reducing the cost of the call option. Or it could be that 5-year is not the longest term. We see many six-year products," Hampson said.

But she said that investors should distinguish between the terms of a structure and the potential of an investment.

"Obviously having better terms in your deal doesn't mean that the notes will perform better," she said.

"This is for risk-adverse investors because their principal is protected at 100% against any index decline. But they need to be aware that they're still subject to the bank's credit risk," she said.

The notes will price in August and settle in September.

Merrill Lynch, Pierce, Fenner & Smith Inc. is the agent.

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