Bank of America's six-month bearish Stars linked to Russell 2000 offer bearish bet, hedge

By Emma Trincal

New York, Feb. 10 - Bank of America Corp.'s 0% bear market Strategic Accelerated Redemption Securities due August 2012 linked to the Russell 2000 index target investors who want to take a short-term bearish bet or hedge a long equity position, said Suzi Hampson, structured products analyst at Future Value Consultants.

"This is a bearish note that can be used to capture a target return, or it can be used to hedge a long equity portfolio," she said.

The notes will be called at a premium of 6% to 10% if the index finishes at or below the initial level, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not called, investors will lose an amount equal to the index gain.

Bearish play

"The investor would have to make some directional bet here because if the index finishes up, he is sure to lose money," she said.

Hampson said that many products are constructed with a similar payout. What is different here is the bearish aspect of the notes, which is less common.

"Those bearish notes are not that common. But while it's the opposite market view of a bullish digital or autocallable note, it works pretty much the same way," she said.

"For instance, you're not taking a strong bearish bet here. You're not predicting a huge crash. That's because you'll outperform when the index is flat or up to a point, up to the cap. It's the same idea with the bullish equivalent product: you'll make money if the index remains flat and you'll outperform the tracker if it appreciates up to the cap. These bullish or bearish notes are not designed for the very bullish or very bearish investor," she said.

Following the methodology of her firm, which sets prices within 75% of the range, she assumed a call premium of 9% for the six-month term.

"Eighteen percent a year, even if the index is flat, is quite a good return," she said.

"Most of the products we see are the other way around. But it's the same as a note tied to the appreciation of an index. Compare it to an equivalent tracker that would short the same benchmark.

"If the Russell is flat or down by less than 9%, you are going to outperform the tracker. However, if it finishes down by more than 9%, you'll underperform.

"If it's up, you'll lose money. It can happen fast. But keep in mind that for you to lose 100% of your principal, the index would have to drop by 100% in six months. In any event, you have the same exposure to the tracker on the downside."

Still, if the market were to go through a big sell-off, the notes would lose their appeal because the return is limited to the premium, as stated in the prospectus.

"It's capped. But if the index is flat, if it doesn't move, you still get 9%," she said.

"In addition, this is only six months. You're not locking in your money for a long time.

"There's got to be some compensation for that, and that's the unlimited downside if the index is up."

Technically, the notes could fit into the autocallable category with only one observation date.

"It's more like a bearish digital product or bearish kick-out because it gives you a fixed return," she said.

Unlike an autocallable note that allows for an early exit, these notes will not offer any early redemption, she said.

Strategies

Making the decision to take a slightly bearish bet ultimately is up to the investor, she said.

"These products are meant to solve investment strategies," she said.

"You may want to take a bearish directional bet. But it's probably not the only reason you would consider this note.

"Some may want to have a fixed return. It may appeal to someone who has a target return in mind and who thinks that the probability of getting that 9% is higher with that product than with other securities.

"Obviously you're limiting your return to 9%. But is 18% a year really a limitation for an investor who has that target in mind? In fact, many investors would have lower targets."

Another use for the notes would be risk mitigation.

"If you have a long equity position and if you worry about a market sell-off coming up soon, this could be used as a hedge," she said.

Risk

The notes present some risk, Hampson noted, pointing to their riskmap.

Riskmap is a Future Value Consultants rating that measures the risk associated with a product on a scale of zero to 10. The higher the score, the greater the risk.

The product has a riskmap of 5.08, which is more than the average of all products at 4.75.

Reverse convertibles contribute heavily to the average of all recently rated products.

"If the bearish notes show more risk, it's because they don't offer any downside protection while reverse convertibles do. A lot of the other products in fact have some sort of barrier or buffer mechanism, which makes the general average less risky than this one," she said.

The riskmap is the sum of two risk components: market risk and credit risk.

At 4.22, the market riskmap of those notes is slightly higher than 4.13, the average for all products.

"Most of the risk falls under market risk here due to the lack of downside protection," she said.

The 0.86 credit riskmap is greater than the 0.62 credit riskmap for the average of all products.

"We can attribute that difference to the issuer's creditworthiness. Duration is not an issue here."

Credit risk increases with the counterparty risk as well as with the duration of a note, as time raises the probability of a default, she explained.

Risk-adjusted return

Future Value Consultants gives its opinion of the risk-adjusted return with its return score.

The score is calculated from five key assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. Future Value Consultants calculates a risk-adjusted average return for each assumption. The return score is the best of these five returns.

This product shows a 6.07 return score. This is lower than all other products, which have an average score of 6.45.

"This is a risk-adjusted rating. As the risk is quite high here, we expected a higher return to compensate investors," she said.

"Keep in mind that the product has not priced yet. We made the 9% assumption for the call premium. If it prices at 10%, obviously the return score would increase."

The return score is derived from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

When using the neutral assumption, which is a risk-free growth scenario, the notes show a 38.4% probability of losing more than 15% per year. The odds of making an annualized positive return of more than 15% are 45.8%.

But the return score is calculated based on the best among the five return scenarios, which for this particular product would be the low growth assumption, said Hampson.

In this optimal scenario, the probabilities improve notably, she said, pointing to a 30.4% chance of losing more than 15% and a 53% chance of making more than 15% a year in gains.

Price, overall

Future Value Consultants' estimate of the total costs taken out of the product from direct fees and profit margin on the underlying derivative is measured via the price score.

The notes have a 5.82 price score, compared with 6.93 for the average of all products.

"It's quite less. There could be a penalty here for having a short maturity," she said.

"Products with longer maturities get better price scores because we look at annualized costs."

The lower price score negatively impacted the overall score, which is Future Value Consultants' opinion on a quality of a deal. It is based on the average of the price score and the return score.

The notes received a 5.95 overall score, compared with 6.69 for all other products.

Bank of America Merrill Lynch is the underwriter.

The notes will price and settle this month.

The exact deal terms will be set at pricing.

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