Bank of America joins volatility club with $65.11 million notes tied to Investable Volatility

By Emma Trincal

New York, Sept. 27 - Amid the growing popularity of volatility-linked products, Bank of America Corp. is joining the fray with its $65.11 million of 0% Strategic Return Notes due Sept. 25, 2015 linked to the Investable Volatility index.

The Investable Volatility index, a proprietary index of Merrill Lynch International created in March, was used for the first time in last week's offering, Yoni Epelbaum, head of structured products in the United States at Bank of America Merrill Lynch, told Prospect News.

The index provides a measure of market volatility in the equity markets and is designed to measure the return of an investment in the forward implied volatility of the S&P 500 index for a three-month period with a mid-point about five months in the future, according to a 424B2 filing with the Securities and Exchange Commission.

Sources said that Bank of America is looking to offer investors an alternative to existing competing products, such as Barclays Bank plc's popular iPath S&P 500 VIX Short-Term Futures exchange-traded notes.

Epelbaum declined to say if an ETN linked to the Merrill Lynch proprietary index was in the works.

Commenting on the popularity of the first-time deal, he said that it had been sold "mostly to retail investors."

A new approach

Instead of using the CBOE Volatility index, commonly known as the VIX, as a measure of the implied volatility of the S&P 500, Merrill Lynch in its index methodology relies on forward implied volatility.

Forward implied volatility between two dates in the future is calculated using the current implied volatility of options expiring on each of the two dates, according to the prospectus.

"We believe our product is stronger than other products out there because other products are based on VIX futures, which are less liquid than the prices of listed S&P options we're using, and secondly because of the longer maturities we're trying to track, which benefit investments in volatility," Epelbaum said.

Investable

"We made an index using the same methodology as VIX in terms of taking a particular volatility of different maturities," Epelbaum said.

"But instead of using the front end of the month, we went a little bit longer, between the three- or six-month and the nine-month. The average maturity of all options we use is approximately five months."

One inconvenience of using the VIX as a gauge for implied volatility, a market source explained, is that "when you buy a package of options and hold them, they lose value every day, and so the VIX cannot be traded."

The Investable Volatility index aims to remedy this problem by incorporating in the strategy a "sell" component, Epelbaum noted.

"We don't just buy options with our index. We also sell some options," he said. "By selling the options as well as well as buying them, you can hold on to a strategy that can be traded, unlike the VIX. We're trading forward volatility instead of plain implied volatility."

One of the objectives of the Merrill Lynch proprietary index is also to reduce holding costs, Epelbaum explained.

According to a Bank of America fact sheet related to the index, the longer-dated volatilities on which the index is based can reduce holding costs as they typically sit on a flatter part of the volatility curve with more moderate holding costs.

"Our index measures the implied volatility happening from approximately three months from today to approximately six month from today. You can make the index investable. The average maturity of all options is always the same, about five-month," Epelbaum said.

Popular asset class

Volatility-linked notes, whether packaged in an ETN or in a regular note format, have grown increasingly popular, data compiled by Prospect News shows.

As an example, Barclays earlier this month priced an additional $2.5 billion of its iPath S&P 500 VIX Short-Term Futures ETNs due Jan. 30, 2019. Since inception in January 2009, the issuer has priced $14.5 billion of these notes.

Commenting on the new Bank of America note as well as volatility products in general, Matt Medeiros, president and chief executive officer of the Institute for Wealth Management, said, "I think it's a really good idea because most investment decisions are made based on some sort of market momentum or fundamentals and the probabilities of this continuing going forward. Volatility allows you to have those forward-looking views, but it also creates a short-term hedge against your long-term views."

Medeiros noted that volatility strategies can give investors some protection against tail risk.

"In 2008-09, we went into a liquidity event during which all asset classes sold off. At the same time, volatility, which is negatively correlated to most asset classes, was going up. It was a valuable hedge," Medeiros said.

Complexity

Not every adviser is inclined to embrace volatility as a market strategy.

"Generally, we would not be a player on volatility strategies," said Carl Kunhardt, director of investment management and research at Quest Capital Management. "We're not market timers, and we still follow a strategic asset allocation. And while we may be from time to time hedging against market movements or taking advantage of them, it hasn't been our principal objective."

But Kunhardt's main objection to volatility-like strategies is the complexity of those new products as volatility bets require deep levels of knowledge that only a few investors have, he said.

"I don't think using volatility as an asset class is a mainstream investment strategy. The majority of retail investors don't even really understand what the VIX is," he said. "With sophisticated investors, it's a little bit different. The VIX has been a followed index for as long as I remember. They use it to hedge. But I don't think the same applies to retail investors. My clients are so worried about losing money and keeping money, they're not likely to pay much attention to what looks like an exotic strategy to them."

Hedging a selloff

Epelbaum said that volatility strategies speak for themselves in terms of the diversification and hedge benefits they give equity investors. As a result, investors have paid attention, he noted.

"The mathematics of a volatility index can be complicated, but the benefits of adding volatility to an equity portfolio are understood from a correlation perspective," he said.

Traditional asset classes such as bonds, international equities or commodities often fail to produce diversification benefits during significant equity market downturns, Epelbaum explained.

"Volatility is very negatively correlated to equities over time, which is helpful as a hedge during a market sell-off."

The index fact sheet pointed to the benefits of using the index as a hedge in an equity portfolio and said that a hypothetical 20% allocation to the index outperformed the S&P 500 benchmark by approximately 19% and was approximately 43% less volatile.

Exchangeable notes

Beginning in October 2011, the notes will be exchangeable during the first 15 days of January, April, July and October of each year, according to the filing.

For each $10.00 principal amount, the payout at maturity or upon exchange will be $9.80 plus the index return. The final index level will be reduced by an index adjustment factor of 0.75% per year, which accrues daily.

The initial and final levels of the index will be averaged over five trading days.

In order to receive at least par at maturity or upon exchange, the level of the index must increase by more than 5.93% from the starting value.

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

The fees are 2%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.