Bank of America's $55.24 million 8.5% STEP Income notes on Schlumberger offer bonus for bulls

By Emma Trincal

New York, May 18 - Bank of America Corp.'s $55.24 million of 8.5% STEP Income Securities due May 25, 2012 linked to the common stock of Schlumberger Ltd. are "enhanced reverse convertibles designed for investors who are more bullish on the stock," a market participant said.

Interest is payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

If the final price of Schlumberger stock is greater than or equal to the step level - 108.5% of the initial share price - the payout at maturity will be par of $10 plus 6.47%.

If the final share price is greater than or equal to the initial share price but is less than the step level, the payout will be par.

If the final share price is less than the initial share price, investors will be exposed to the decline.

Investors receive a step payment at maturity if the stock ends greater or equal to the step level.

Enhanced formula

"Traditional reverse convertibles are more common. But we've seen the development of these enhanced versions where you get a coupon plus an additional payment if the stock ends above a certain threshold. You get two potential coupons," the market participant said.

If the stock price ends higher than the step level, investors have the opportunity to generate nearly 15% in returns for the one-year term, according to the terms of the deal when adding up the interest payments and the step payment.

"A reverse convertible would give you a higher coupon than this. But with this, if you get above the step, you get an additional coupon and you may end up better. It's an upside bonus," he said.

It's for bulls

"This deal is for investors who are a little bit more bullish than reverse convertible investors," the market participant noted.

"First, they want to extract value as the stock price goes up, and that's what the step payment offers.

"Second, you don't have any buffer. Not that it's impossible to find a reverse convertible note without a buffer. But typically they have one. Because you don't have any downside protection with these notes, you really need some kind of bullish view."

In contrast, investors in reverse convertibles would get a higher coupon on the view that the stock will trade range bound between the downside barrier and the coupon, he added.

"They could have given you a buffer with this deal. But the structure would have been more complex. In addition, you would have had a lower coupon," he said.

15% maximum

While this structure reflects a more bullish view than the view held by the buyer of a traditional reverse convertible on the same stock, it would not fit a very bullish outlook as there is a fixed potential return of 15%.

Returns are limited to the periodic interest payments and the step payment if any, according to the prospectus.

"This is not the right investment for somebody who thinks the stock may rise above 15%," said Kirk Chisholm, financial adviser at NUA Advisors.

"For someone very bullish on Schlumberger, this is not the appropriate investment.

Chisholm added that very bearish investors would not find the deal attractive either.

"You get paid the 8.5% coupon no matter what, so it's a form of protection," he said. "But if you think the stock is going to decline by more than 8.5%, this is not the right product.

"Ideally, you want the returns to be anywhere between zero and 8.5%. Then you're in great shape.

"You have to have a very specific view on the stock for this investment to make sense."

Sector risk

Chisholm said that while he liked Schlumberger as an oil and gas company, there were "too many unknowns" in today's macroeconomic environment to make him comfortable with the deal. He pointed to possible changes in the Federal Reserve's monetary policy, in particular the nearing end of its Treasury purchase program known as QE2.

"If QE2 stops at the end of next month and is not restarted in the next 12 months, which is when the notes end, Schlumberger's stock price will most likely suffer," Chisholm said.

"I don't have a problem with the company, but I am bearish on commodities for the short term or at least for the next year. The end of QE2 is likely to push the dollar higher and commodities prices lower. And you have to take into account those macroeconomic factors when you invest in an oil stock," he said.

Chisholm said that the commodities market correction, which began this month, was triggered by the "repositioning of institutional portfolios" in anticipation of the Fed's moves next month.

Bank of America Merrill Lynch is the agent.

Fees are 1.75%.

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