Bank of America's notes tied to oil aim for moderate bulls, but oil price swings seen as risk

By Emma Trincal

New York, Jan. 18 - Bank of America Corp.'s $41.66 million of 0% Capped Leveraged Index Return Notes due Jan. 23, 2014 linked to the price of light sweet crude oil are for investors who do not anticipate a big rise in the price of oil three years from now, according to a 424B2 filing with the Securities and Exchange Commission.

But given the volatility of the commodity, this bet puts investors at a high risk while the upside potential is limited, sources said.

The payout at maturity will be par of $10 plus double any increase in the price of oil, subject to a maximum return of 34%. Investors will receive par if the price falls by 10% or less and will lose 1% for every 1% that it declines beyond 10%.

The initial oil price at pricing was $91.86.

Trading sideways

"You have to have a view and anticipate that the price of oil is going to trade in a narrow range, within a $75 to $110 band," a market participant said.

"This narrow range has to be the assumption to make this deal attractive. If the price of oil has a low level of appreciation, then it's a good deal. It has a good risk/return ratio."

"If oil goes up or down 20%: worse-case scenario, you lose 8%, and best-case scenario, you hit the 34% cap, which is attainable at the price of $107.

"But once you start getting outside that plus/minus 20% range, you lose. And I just don't see how oil can avoid having big swings within three years. That's my personal prejudice. Based on the volatility of oil, I see a 90% probability for oil to trade outside of this $75 to $110 range."

Bearish scenario

This market participant said that oil prices would likely hit the $100 threshold but that the investment was "a big gamble" since prices could easily fall thereafter.

"Maintaining a level above $100 would require an economic boom. The weak economic environment will not support a sustained increase and prices are very likely to collapse," he said, adding that oil prices could go back down to their 2008 levels at $40 or $50.

"In that case, you could easily breach the 10% barrier on the downside. I don't know if the barrier will be breached in three years, but I expect the barrier to be breached within three years. So you're taking a big chance," he said.

The market participant said that the strategy offered by the notes had too much risk for the potential upside given the volatility of oil and the 34% cap on three years, the equivalent of 11% per year.

"The leverage in the deal is a bogus incentive," he said. "They give you 5.5% a year and after that, your return is capped. It's very unlikely that you would have only a 5% swing in oil."

Options alternative

The market participant said that a better strategy for an investor betting that the price of oil will rise moderately would be to use options.

"With an arrangement of puts and calls, you could replicate the downside protection while keeping your upside unlimited," he said.

He recommended buying calls for upside exposure and to buy a put for the downside protection.

"Say you would buy calls at a strike price of $105 for instance, which would give you the unlimited upside, and a put at a $95 strike price for the downside protection," he said.

"You would lose all of your options premiums if the price finished between $95 and $105.

"Above $105 you would make money with the calls, offsetting the cost of your premium, and below $95 you would make money with the put, offsetting some of your cost as well.

"You would know what your maximum potential loss is going to be, and your upside would not be limited."

Liquidity risk

Donald McCoy, financial adviser at Planners Financial Services, agreed that the risk/reward trade-off was not favorable to the investor. His main concern was the relatively illiquid nature of the investment.

"To me this seems like a bad risk," he said.

"You can invest in a mutual fund or an exchange-traded fund that would give you oil exposure and get the two-times leverage too. You don't get the downside protection, but you have the liquidity. You can do it on your own free time, you don't have to sit around for three years, and you're not capped at 34%."

McCoy also pointed to the volatility of the underlying commodity as a risk factor with the notes.

"It only works for you if oil trades in a band in the next three years."

He picked $107 as the price at which investors maximize their returns - a roughly 16% increase of about 16% from the starting value, which approximately offers investors the 34% desired maximum return over the period - and said, "You make money if oil goes up by $15 in three years. But oil can do that in a month! I wouldn't be too excited about this deal."

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

Fees were 2.25%.

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