Bank of America's autocallables linked to Amazon, JPMorgan seen as new version of old worst of

By Emma Trincal

New York, May 30 - Bank of America Corp.'s upcoming autocallable notes due June 2014 linked to the common stocks of Amazon.com, Inc. and JPMorgan Chase & Co. were viewed by market participants as an intriguing and relatively new type of hybrid structure. The product combines an automatic call with a worst-of feature.

"I can tell you that I've never seen that structure before," a market participant said.

If each stock closes at or above 70% of its initial value on a quarterly observation date, investors will receive a conditional coupon payment of 3.75% to 4.75%. Otherwise, no contingent coupon payment will be made for that period. The exact conditional coupon will be set at pricing.

If the closing share price of each stock is greater than or equal to the initial share price on any quarterly determination date, the notes will be automatically redeemed at par plus the conditional coupon payment.

If the notes are not called and the final share price of each stock is greater than or equal to the threshold value - 80% of its starting value - the payout at maturity will be par plus the conditional coupon payment. If the final share price of either stock is less than the threshold value, investors will lose 1% for every 1% decline of the worst-performing stock beyond 20%.

"They have incorporated a worst-of feature into an autocallable as well as a buffer at maturity. That's pretty interesting," the market participant said.

"It's a buffered deal with bells and whistles," a structurer noted. "The combination of an autocall and worst of is a little bit unusual. I'm not sure I've seen it before, but the technology employed in each component of the product is the same."

Correlation risk

The use of two stocks as reference assets for this product represents a slight difference from the usual worst-of product, according to the structurer, albeit a minor one.

"Most worst of are based on indexes," he said.

"But whether you structure it on the shares or on the index, the technique is the same. I've actually seen them done on baskets of stocks," he said.

More relevant is the low correlation between Amazon and JPMorgan, this structurer noted.

"The fact that there is no or little correlation between the two is not an advantage for the investor," he said.

That's because with worst-of deals, investors are hoping that the underlying assets will move in synch, which is the equivalent of being long correlation. Investors are betting that both assets will be moving together in a positive direction, he explained.

"Both stocks have to be above 70% every quarter for you to get your full coupon. Both have to be above par to get called on any quarter. And at maturity, both stocks have to close above 80% for you to get your principal back," he said.

Volatility, payout

The market participant observed the relatively high levels of implied volatility of both stocks - especially JPMorgan, which, he said, has an implied volatility of 40%, while Amazon's is 34%, also above the market level.

"They took a couple of household names that investors are familiar with but that happen to have pretty decent levels of volatility," he said.

At the same time, the inclusion of volatile stocks in the underlying has a positive impact on the terms of the product, the structurer noted.

"The benefit for selling the downside is paid to the investor with a potential 3.75% coupon each quarter, which is a double-digit annualized return. It's not bad. I have no problem with that as long as investors understand the risks. There are no bad structures. There are only bad sales practices. The investor is selling a put. The question is how do you make the put attractive enough so that the perceived risk is not seen as too much," he said.

He pointed to the risks.

"Because the two stocks are not correlated, there are two chances the structure can hurt you. That's part of the game. You take that type of risk so that you have a chance to get a decent coupon, especially when you don't get anywhere with Treasuries," he said.

"It's also attractive because it gives you several benefits in one product: the conditional coupon, the autocallable feature and the 20% buffer.

"Obviously, an issuer couldn't price this with just one name."

One flaw in the structure may have been its relative complexity, the structurer added.

"They give you a 70% threshold on the quarterly return, but it's an 80% level at maturity for the final barrier. It's a little confusing. Normally, it's the same level. But banks' prices are based on probabilities, and this must have come up as the right price. Nothing wrong with that, but you have to read it carefully," he said.

"An investor in these notes can't be bearish on both stocks. He can't be too bullish on those names either since the upside is capped at the coupon level. If one was to be comfortable or moderately bullish on both names, then it would be a trade for that particular type of investor."

New game

Some see in this atypical product a sign of evolution of the traditional worst of.

Traditionally, worst-of notes took the form of reverse convertibles, the market participant explained. The upcoming Bank of America product is different in that the barrier is replaced by a 20% buffer. Additionally, the reverse convertible format changes into an automatic call feature.

"Your principal is still at risk since you can lose up to 80%. But unlike a reverse convertible, it's a hard buffer, not a barrier," he said.

"They've put together different pieces: the worst of, the autocall, the buffer, one from column A, the other from column B and from column C.

"It looks like it's a new way to sell a worst of, a structure that went out of fashion after the Lehman crisis. You had many more worst-of structures prior to the Lehman collapse than you have now. So they're replacing the old version, the reverse convertible version, with an autocallable product.

"But if we had a sell-off in equity, these worst of in the form of an autocallable would lose their audience just as quickly as the reverse convertible worst of did."

Investors' tolerance for the introduction of new risks has its limits, he said.

"If the market goes down, people are not going to be willing to get exposed to correlation risk. They're not going to want to take any additional risk on top of market risk."

The notes (Cusip: 06051R352) will settle in June.

Bank of America Merrill Lynch is the underwriter.

The fees are 1.5%.

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