Bank of America's Mitts tied to Dow Jones - UBS Commodity Excess Return tap need for safety

By Emma Trincal

New York, Jan. 30 - Bank of America Corp.'s 0% Market Index Target-Term Securities due February 2017 linked to the Dow Jones - UBS Commodity Index - Excess Return target investors seeking capped exposure to commodities with full principal protection subject to the issuer's credit risk.

Sources said that the benefit of principal protection with this volatile underlying more than offsets some of the drawbacks such as the long duration and the cap.

The payout at maturity will be par plus any index gain, up to a maximum return of 45% to 55%, according to an FWP filing with the Securities and Exchange Commission. The exact cap will be set at pricing.

If the index falls, the payout will be par.

Carl Kunhardt, wealth adviser at Quest Capital Management, said that the notes offer the advantage of giving investors access to a non-correlated asset class while delivering peace of mind.

"I like it and I would use it," he said.

"It's tied to commodities, a non-correlated asset, and as such, it would fall into our alternative investment bucket.

"But it's far safer than a pure play exposure, and it's going to reflect less volatility."

Long-term commitment

One of the risks of principal protection is that investors may not earn a return on their investment after a relatively long period of time, according to the prospectus. Investors may also earn a lower yield than other fixed-income products.

"You have to compare this opportunity cost with a comparable investment that also gives you full principal protection," said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

"What would you earn with a five-year CD? If it's 2% a year, it means that you've lost 10% relative to the CD in five years. You're not really losing that much in a down or mediocre market. I don't see that as a deterrent."

For Kunhardt, the long-term aspect of the deal was more of an advantage than a problem.

"My job is to keep my clients invested for the long haul so that they can enjoy the benefits of their investments. With that, I manage to get clients to stay in because they don't have the usual emotional response to say 'Get me out of here!'

"They see on their statement the same value each year. I'm insulating them from volatility of the asset class because they won't see it. That way, they get the benefits of the low correlation of commodities with potential appreciation."

"It gives you the long-term perspective. It's just not a trading vehicle," said Kalscheur.

Another risk is to earn less than a direct investment in the index as a result of the cap. If set at 50%, the cap would limit investors' returns to that percentage at the end of the five years, according to the prospectus.

"I'll take 10% a year anytime if I have the principal protection," said Kunhardt.

Diversification

For Kalscheur, investors in this note are not taking strong directional bets on commodities. Rather, they want to diversify their portfolio and fit into the mildly bullish profile.

"People who directly invest in commodities usually do it for two reasons: to obtain some diversification from stocks and bonds and to get a hedge against inflation," he said.

"If you think inflation is going to be rampant in five years, if you're very bullish on commodities, this is the wrong product, obviously.

"But if you see inflation on track for the next five years and want to get diversification and protection again rising prices, then this is a good way to do it. If the index is up 100% after five years and you make 50% in return, are you really going to sit around and complain about it?"

Uncle Sam

As with other principal-protected notes, the tax treatment may sometimes be less favorable than most capital-at-risk products.

According to the prospectus, investors will be required to report the so-called "OID," or original issue discount, which is an interest income based on a "comparable yield" and a "projected payment schedule" established by the issuer for determining interest accruals and adjustments with respect to a note.

"It's something to be aware of with these products. I get this question all the time. But I certainly don't see that as a drawback. You just have to put the client in an IRA or a Roth, not in a taxable account," said Kalscheur.

"You'll never escape the taxman," said Kunhardt. "I still don't see anything there not to like."

Credit risk

While investors benefit from 100% principal protection, payments are subject to the issuer's creditworthiness. The credit risk is higher with long-term products though, observed Kalscheur.

"Counterparty risk is a significant issue for us. And while I don't see Bank of America going out of business, among all the other banks, they tend to be higher on the list of banks we're less comfortable with," said Kalscheur.

"For this reason, I would be hesitant to take a large position. First, I don't think this is a stand-alone product. I see it more as a complementary position for an existing commodity exposure, something to put in a portfolio in addition to active management or an index. But the credit risk, especially over five years, would reinforce this view.

"This product fits the bill as a nice complement. It has a decent upside. It gives you inflation protection and diversification. I just wouldn't want this to be my only exposure to commodities."

"Credit risk is not a concern for me," said Kunhardt. "Bank of America will be here for the next five years."

The notes are expected to price in February and settle in March.

Bank of America Merrill Lynch is the underwriter.

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