Bank of America's Mitts on Hang Seng, Dax and iShares MSCI Brazil offer protection, long tenor

By Emma Trincal

New York, Jan. 24 - Bank of America Corp.'s 0% Market Index Target-Term Securities due January 2018 linked to a global equity basket offer investors exposure to big exporting countries with full principal protection, but the trade-off is a long tenor, sources said.

The basket consists of the Hang Seng China Enterprises index with a 40% weight, the Dax index with a 40% weight and the iShares MSCI Brazil index fund with a 20% weight, according to an FWP filing with the Securities and Exchange Commission.

"Why would you build a basket combining Hong Kong, Germany and Brazil? To me, it's a play on exporting countries. Hong Kong is the hub of Asia; Frankfurt is the financial center of continental Europe; and Brazil is the powerhouse of Latin America. They're giving you a global exposure to three regional hubs," said Richard C. Kang, chief investment officer and director of research at Emerging Global Advisors.

The payout at maturity will be par of $10 plus any basket gain, capped at 85% to 100% over the original offering price. The actual capped value will be determined on the pricing date. Investors will receive a minimum of par.

The ending basket return will be the average of the basket return on five calculation days that are scheduled for shortly before the maturity date. The calculation dates will be determined on the pricing date.

Hedging challenge

"It sounds like a better deal than I would expect," a market participant said.

"I'm amazed that they can offer that with a complete principal protection. You get reasonable upside participation with that high of a cap. I'm wondering how they can hedge that."

Investors in the notes are not entitled to receive dividends paid by the stocks included in the basket components, except to the extent that dividends are reflected in the level of the DAX, according to the prospectus.

"By not paying dividends, they're capturing about 1.5% to 2.5% a year in dividends, which helps. That's one way they can do it," the market participant said.

"Another way obviously is the cap. It helps with the cost of hedging."

But extending the maturity was also designed to lower the cost of some options, such as long calls, which tend to be "under-priced," he said.

Long tenor

It's up to investors to decide whether they are willing to tie up their money for a period of seven years with the risk of earning no return at maturity, he added.

The 85% to 100% cap over the period is the equivalent of a 12% to 14% annualized return.

"If you know this is the duration you want, you're getting an above-average yield. A 12% to 14% annual return is above current seven-year zero-coupon rates at approximately 4%," he said.

"But again, you have to be willing to make a non-liquid investment. Your money will be tied up for seven years, and for seven years you're not going to be able to rebalance."

Bulls and bears beware

The main benefit of the structure is to offer principal protection on an exotic underlying basket, sources said.

But for some investors either very bearish or very bullish on the underlying stock markets, the notes represented a risk despite the principal-protection feature.

"I would not invest in China. China will be the next crisis to hit the financial system. Within a seven-year timeframe especially, they'll be going through a major crisis," said Peter Rup, chief investment officer at Artemis Wealth Advisors.

"They're running a very risky experiment. One the one hand, they have a serious inflation problem they need to contain. But raising interest rates and revaluating their currency would cool off their economy very rapidly and cause social unrest.

"I don't believe they're seriously interested in cooling off their economy. And it will come back to haunt them."

Kang, who is on the contrary very bullish on China as well as on emerging markets in general, said that he would not consider the notes because of the cap.

"This note gives you about seven years to double up your returns," he said.

"But we're talking China and Brazil. What if you believe that emerging markets are going to hit higher gear and pull the U.S. and others out of this slump? Then doubling up your money might seem like a joke. A three times or five times return over the seven-year period might be more like it. As a bullish investor, I would worry about the opportunity cost of these notes."

© 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.