Bank of America's 90%-protected Mitts tied to the Dow make losses more likely, but small

By Emma Trincal

New York, Oct. 19 - Bank of America Corp's 0% Market Index Target-Term Securities due October 2018 linked to the Dow Jones industrial average offer investors a different way to protect capital "somewhere in the middle" between a full principal protection and a buffer, said Suzi Hampson, structured products analyst at Future Value Consultants.

Investors see their losses capped at 10% versus no losses in a full principal protected product, she said. This limitation increases the odds of a loss compared to a buffered note. On the other hand, the size of the potential losses is considerably reduced.

The payout at maturity will be par of $10 plus any gain in the index, up to a maximum return of $15.00 to $16.00 per note, according to an FWP filing with the Securities and Exchange Commission.

If the index falls, investors will be exposed to losses of up to 10%, with a payout of at least 90% of par.

"You want to invest in this if you're bullish and if you're ready to lose 10% of your money," said Hampson. "Your upside will be capped at 50% to 60%, which is about 9.5% per year. That's not bad."

The hypothetical cap used by Future Value Consultants for its score is 57.5%.

Hampson said that notes such as this one with a partial protection are not very widespread.

"This type of investment allows investors to participate in the upside while protecting their capital. But it's not a typical principal protected product since the issuer only guarantees the return of 90% of principal and not all of it. For the very conservative investor, it makes a difference," she said.

Separately, the buyer of capital-at-risk products may not be deterred from bidding on his preferred product - a note with a downside buffer or barrier.

Probabilities and losses

"A 90% protected note is completely different from a note with a 10% buffer," she said.

"We see a lot of buffered products aimed to reduce the risk. If you think the index is going to fall, you get protection from the first 10% losses after that, you will suffer. That's the idea behind a buffered note.

"With this, it's quite the opposite. If the index falls, you will lose the first 10% of your investment but up to 10% and that's it. There is a limit to what you can lose," she said.

However, by limiting the size of the potential losses, investors increase the probability of losing, she explained.

"You are less likely to lose more than 10%, but if you do, you could lose a lot. In fact, you could lose almost everything except for the 10% buffer. It's the other way around with this product. Here, the loss is more likely to happen but it will be limited to 10% of your principal. It's as if the investor was willing to take a likely loss so long as he knows that the loss will be small.

"Some people may have more comfort with that. At least you know your maximum loss is 10% apart from a credit event. But even though it's called principal protection, it's a very different model than the classical principal-protected product. And it's very different in essence from a buffer," she said.

Hampson noted that partially protected notes are not very common either in the United States or in the United Kingdom.

One reason may be that investors who buy the full protection type are not willing to tolerate any risk aside from the credit risk, she said.

"The fact that the principal protection is 90 instead of 100 can give you better terms. But the very cautious investor who typically buys the 100% principal-protected notes is going to care about one thing: not losing any principal at all, not even 10% of it," she said.

Alternatively, investors in capital-at-risk products seek buffers as a way to mitigate risk but not to a point of sacrificing higher returns, she added.

"So we don't see that many partially protected notes because they are too much of an in-between category. Cautious investors and risk-takers may not find them appealing and for different reasons," she said.

Another factor may also be that partially protected products offer fewer opportunities to outperform the underlying index, she said.

"With a 10% buffered note, a decline of the underlying by less than 10% will make you outperform the benchmark putting aside dividends. With a barrier, you also have a chance to outperform as long as you don't hit the downside trigger. But with a 90% protected note, you're likely to do the same as the index, not better, because the probabilities of the index decline are greater on the first losses," she said.

Ratings

According to Future Value Consultants' report, the six-year Bank of America Mitts tied to the Dow Jones index offer less risk and a good risk return potential. But the pricing is disappointing, she said.

The risk associated with a product is measured by Future Value Consultants' riskmap on a scale of zero to 10. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk, which are rated on the same scale.

The notes show a 3.65 riskmap, which is less than the riskmap observed for the average of all products, at 4.09.

"This is because you can only lose 10%, which is a small amount of principal," she said.

"The riskmap depends on the amount of losses as well as of the chances of losing money. The low riskmap in this particular case reflects the fact that losses are small in size.

The same factor also drives down the 1.71 market riskmap, which is much lower than 3.34 for the rest of the population made of recently rated deals, all structures included, which the firm calls "all-products."

The comparison with similar products - which would be notes offering a downside protection of approximately 90% as well - is less relevant, she said.

"Partially protected products represent a very small sample as the structure is not often used. As a result, scores can be easily skewed, essentially due to different pricing dates or variable volatility levels."

On the credit risk score, the notes, with a 1.95 credit riskmap, suggests a higher issuer's risk than the average of all products, which is 0.75. This difference could reflect the creditworthiness of Bank of America, but Hampson said that it was not the main reason.

"We're looking here at the maturity factor. The "all-products" category comprises a disproportionate number of shorter-dated notes, essentially reverse convertibles, which can have three, six month tenors and you're comparing these with a six-year product. It's going to greatly elevate the credit risk," she said.

Return score

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions - neutral assumption, high and low growth environments, and high and low volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score, also measured on a scale of zero to 10, is based on the best of the five scenarios.

For this product, the best scenario would be "high growth," she said.

Under this assumption, investors have a 57% chance of getting an annualized return comprised between 5% and 10%, while they have a 22% probability of earning from zero to 5% annually. This gives investors about 80% chances of scoring a positive return, she said. For the losses, the size bucket is between zero and 5% per year associated to a 20% probability.

These probability tables reflect a relatively high return score of 7.38 compared to 6.57 for all products, she noted.

"We're looking at expected returns for a given level of risk. The score is based off the best performing scenario, which would be high growth in this case. If it's growing year after year at a decent pace and you're taking less risk than other products, you can end up with a high return. The cap is quite high at 9% per year and all that gives you a good return score," she said.

Price, overall

Future Value measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

With a 5.68 price score, the notes are below the 7.05 average.

"It suggests that it's just not as much value for the money as it could be. The issuer could spend more money on the options. If there isn't enough competition, that could also explain the lower price score. We know that there is only a small sample of those products in our database," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

The notes have a 6.53 overall score, which is slightly lower than the 6.81 score for the average of all products.

"On average you have a much better return score but the price score is weak. It gives you an overall score that's only average, despite the good risk return potential," she said.

Bank of America Merrill Lynch is the underwriter.

The notes are will price in October and settle in November.

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