Bank of America's $25.63 million autocallables tease buyers with potential 82% step-up payment

By Emma Trincal

New York, April 17 - Bank of America Corp.'s $25.63 million of 0% autocallable market-linked step-up notes due April 24, 2015 linked to the S&P 500 index are eye-catching for the unusually high potential step-up payment at maturity, sources said. But the likelihood of getting paid at this rate is very slim, they added.

The deal is still attractive in the more likely albeit less profitable event of an automatic call during the term, they said.

The notes will be called at par of $10 plus a premium if the index's closing level is greater than or equal to the initial level on either observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The premium will be $1 if the notes are called April 19, 2013 or $2 if the notes are called April 17, 2014.

If the notes are not called and the final index level is greater than or equal to the initial index level, the payout at maturity will be par plus the greater of 82% and the index return. Investors will receive par if the index declines by 5% or less and will lose 1% for every 1% that it declines beyond 5%.

Unusual

"This one is a little bit unusual for an autocallable," a sellsider said.

He said that most autocallables, unlike this three-year note, are relatively short in duration.

But the most striking difference is the amount to be paid at maturity if the notes have not been called and the same call condition is met, he said.

A call on the first or second year would generate a 10% annualized return. If the "call" were to occur at maturity, investors would earn at least 82%, or 27% per year.

"It's about three times the premium. It's pretty high," the sellsider said.

"The 10% per year from the call premium is a good return. Don't get me wrong. But it's not 27%."

Slim probability

This sellsider explained that investors in this autocallable - as with any other autocallable - are selling a put. Their call premium reflects the value of the put sale premium. If the odds for the put writer to be wrong are great, the compensation needs to be great as well, he said.

In order to earn the step-up payment, investors naturally must not be called on the two call dates in April 2013 and April 2014.

"There's a good chance that you'll get called. That's why they can afford this payout of nearly 30% a year," he said.

"Look at it from a probability perspective. You need to end the first year without being flat or higher. Then you need the index to also be down at the end of the second year and finally, it has to close flat or higher at the end of the third year.

"Down for two years in a row and swing back all the way. It's unlikely you would miss the first two calls and make the last one. It's so unlikely that's why they can pay you a high premium for that.

"Bank of America is not in the business of losing money. They know that in a risk-neutral world, that probability is rather low."

Exotic

The sellsider said that investors get paid a high price at maturity for selling the put because the embedded put is a "complicated" option with conditions.

"The only type of exoticness in this deal is not the selling of a three-year put. The exoticness comes from the premium. You have a barrier option embedded in the premium. That's basically what it is," he said.

"The barrier is pretty clever: down on year one, down on year two but up or flat on year three. There is a huge risk that it's not going to happen, and that's what the premium compensates you for.

"It's a pretty clever idea. I haven't priced it, but it makes logical sense."

Equity category

Scott Miller Jr., managing partner at Blue Bell Private Wealth Management, said that he understands how unlikely reaching the 82% payout is, which is why he would make careful recommendations about the product.

"Definitely, those notes should be targeted for equity replacement. This is not fixed-income replacement or cash replacement. There is downside risk," he said.

"You have a 5% buffer, but if you need to use it, it means the market has not been up. And even though you have that buffer, you're giving up the dividends that the index would pay. So you're taking on the full market risk."

Miller said that the 82% payout is "what makes this note interesting," adding that while "it's the best-case scenario," such outcome is "not very likely."

Risk mitigation

"The important thing to look at is what you're giving up," he said.

"You're taking the market risk - the credit risk obviously too over three years. That's the first thing.

"Second, you are capped. If the market is up 15% on the first year, the most you can make is 10%."

Miller said that the deal must have been popular because it appeals to those investors who hold a range-bound view on market returns.

"I can see two ways to sell it," he said. "The first one would be if the market is up only 1% after one year, you'll make ten times that."

The second way to "sell it," which he said he does not endorse, would be to point out the potential 82% return at maturity.

"Again, it's definitely the best-case scenario, but I am not confident it has a good chance to happen," he said.

"For someone in equity willing to take on credit risk, it could be an interesting note for a portion of the portfolio."

Because of the low probability for highest payout to be paid and the significant downside risk, Miller said that if he used the note, it would be in combination with an option strategy based on the SPDR S&P 500 exchange-traded fund.

"I would use it in addition to some covered call writing on SPY. I'm not getting the huge premium this note could give me on the third year, but it would give me some downside protection and I would have less credit risk," he said.

Bank of America Merrill Lynch was the underwriter.

The notes (Cusip: 06051R782) priced April 12.

The fees were 2%.

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