Bank of America's $44 million callable notes linked to CMS rates appeal to yield-seekers

By Emma Trincal

New York, Aug. 16 - Bank of America Corp.'s $44 million sale of callable capped notes due Aug. 12, 2030 linked to the 30-year and two-year Constant Maturity Swap rates appeared at first glance to be surprisingly big given that the notes generate more return when the yield curve steepens and that the curve is currently flattening, sources said.

The high teaser rate, however, was seen as the main driver in a low-interest-rate market.

The coupon will be 14% for the first year. After that, the rate will be four times the spread of the 30-year CMS rate over the two-year CMS rate minus a strike of 25 basis points, up to a maximum of 14%, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable quarterly and cannot be less than zero.

The payout at maturity will be par.

The notes are callable at par on any interest payment date beginning Aug. 12, 2011.

A good repeat

"That note did very well," a fixed-income trader said.

Bank of America sold a $13.5 million issue of notes last month with terms that were identical except for the maturity date, which was July 12, 2030.

The 14% rate is one of the highest first-year coupons offered in similar recent deals linked to the 30-year and two-year CMS rates, according to data compiled by Prospect News.

Superb 14%

"The big size has probably a lot to do with the high coupon payable on the first year and the fact that people hope to get called," a New York-based rates structurer said. "It could also be that the funding levels of this issuer are pretty wide."

"A 14% rate is superb," said another sellsider. "Even if it's for 20 years, people are ready to take the risk for that rate. And that's a risk."

Bigger, fewer

But others saw in the success of the sale another element: As the curve is becoming flatter, deals offering a bet on a steep curve are becoming less attractive, forcing issuers to introduce attractive terms. In addition, the reduced supply of such deals makes investors more receptive, sources said.

Agents have priced $570 million of notes linked to the spread of the 30-year CMS rate over the two-year CMS rate so far this year in 54 deals, according to data compiled by Prospect News.

Since July 1, only seven deals of this kind have priced for a total of $109 million, indicating that the average size for notes utilizing this underlying has increased to $15.57 million for approximately the past 45 days from $10.55 million for the year.

A turning point

"What gets people into the trade is more than the 14% teaser rate on the first year," the fixed-income trader said.

"We really are at a turning point because the curve is flattening. These trades are getting harder and harder to put together. People have done very well on CMS spread products over the past three or four years. They're still buying it, but we're getting to a point where it will be harder to make money on those trades. In a year or two, it will be over," he said.

The New York structurer agreed that deals enabling investors to make bets on the steepening of the yield curve are being seen less often.

"We haven't seen a lot of those trades on our desk. It's due to the flattening of the curve," he said. "People are buying on the long end of the curve on deflation fears, pushing down the long-term rates."

Better than Treasuries

Carl Kunhardt, director of investment management and research at Quest Capital Management, believed that the notes may have been appealing to some investors as an alternative to low-interest-rate Treasuries.

"It's not so much the call feature. People like the return without having to take a commensurate amount of risk," Kunhardt said.

"It's like buying the long bond but with much more return. You're moving down the capital structure, and you're getting compensated for that. They're giving you a fairly attractive interest rate."

Going down the capital structure means that the notes are unsecured securities issued by Bank of America and that investors are subject to the issuer's credit risk, he said.

"That's the trade-off you're taking for the attractive rate," he said.

Reinvestment risk

Kunhardt said that the outcome of a call depended on how soon the notes would be redeemed.

"If it gets called, it's only a positive in relation to how long you've held the notes. The shorter the notes, the higher the total return of the notes," he said.

A call would not necessarily be a positive for investors if they were facing reinvestment risk, he explained.

"The bank would pull the notes if they found a more attractive way to borrow money," he said.

The prospectus stated that the higher the expected quarterly interest payment is, "the more likely" the issuer is to redeem the notes.

The consequence for investors would be reinvestment risk, said Kunhardt, or the inability for investors to reinvest their proceeds at a rate of return equivalent to what they were getting from the notes.

"You may have your money back, but where are you going to invest it?" said Kunhardt.

Duration

Kunhardt said that he would not be considering the notes for his clients because of the long-term maturity.

"It might be too long of a term for me. I'm still nervous about interest rates. I try to keep duration at around five year[s]. It would fall into what we categorize as alternative investments - structured notes that are not plain vanilla bonds - and it would extend the duration of my entire portfolio. I'm not ready for it," he said.

In addition, Kunhardt said that the 3.3% fee was "a little bit too high."

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

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