Bank of America's autocallable step-up notes tied to PHLX Housing offer unusual, 'fair' payout

By Emma Trincal

New York, May 30 - Bank of America Corp.'s 0% autocallable market-linked step-up notes due July 2015 linked to the PHLX Housing Sector index feature an unusual structure that combines a digital return delivered through a potential one-time automatic call as well as a potential unlimited upside at maturity with a minimum contingent return. In addition, investors benefit from a small buffer, sources said.

"It's a pretty good deal. A very interesting structure," a sellsider said.

The notes will be called at par plus a 10% premium if the index's closing level is greater than or equal to the initial level on the observation date in June 2014, according to an FWP filing with the Securities and Exchange Commission.

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 the step-up payment and the index return. The step-up payment is expected to be 18% to 24% and will be set at pricing. Investors will receive par if the index declines by 5% or less and will lose 1% for every 1% that it declines beyond 5%.

The index is designed to measure the performance of a set of companies whose primary lines of business are directly associated with the U.S. housing construction market.

Attractive terms

"The note has several positives: a short tenor, a nice callable return and no cap to the upside, assuming it is not called," said John Farrall, senior vice president, director of derivatives strategies group at PNC Wealth Management.

"With an expected recovery in the housing market, the reference asset index should be expected to participate."

Participation would be unlimited only if the notes are not called though, Farrall noted. If there is a call, a 10% cap would apply at the June 2014 call date, which would be the only event that would limit the upside. Since the index has shown a robust track record and with a call trigger set at the initial price level, the notes could very well be called, he noted. But even in this scenario, many investors would be satisfied with a 10% return on a one-year period, he said.

So far this year, the PHLX Housing Sector index has gained 15.5%, roughly one point below the S&P 500. Over the past 12 months, however, the PHLX Housing index has strongly outperformed the S&P 500 with a 53% return versus 24.5% for the large-cap equity benchmark.

Since its low in February 2009, the PHLX Housing Sector index has posted a 192% gain.

The implied volatility of this index is 27% versus 13% for the S&P 500.

The underlying index is currently composed of 19 stocks that represent companies involved in the building and prefabrication of residential homes, mortgage insurers and suppliers of building material.

As of April 30, the top holdings in the index were Weyerhaeuser Co. (14.55% weight), PulteGroup, Inc. (9.58% weight), D.R. Horton, Inc. (8.75% weight), Lennar Corp. (7.99% weight) and Fidelity National Financial, Inc. (7.58% weight).

Payout replication

A sellsider said that the "flaws" in the structure appeared "hard to find" but that investors should still compare the payout with what they would be getting from buying the stocks outright.

"You have to compare it with buying the stocks. That's the only way to test it," he said.

"So forget for a moment the credit risk and let's look at what you as the noteholder are going to get compared to the stock buyer and what you have to give up in order to get it."

Among the benefits of the notes, he mentioned the unlimited return on the upside above the step-up level. He hypothetically picked the lower end of the step-up range at 18%.

Between the initial level of 100 and the 118 step level, investors get an enhanced return, the equivalent of a digital payout of 18% over the two-year period, he said.

On the downside, the 5% buffer enables them to outperform the index at all times, even when taking into account dividends.

"You're giving up dividends, but those are only 0.8%. You're not giving up a lot here, and it's certainly less than your 5% buffer. So you'll always outperform on the downside," the sellsider said.

"On the upside, anywhere between 100 and 118, you'll outperform the index. Above 118, you get the index return. So you're not underperforming the index."

The only scenario in which investors would lag the underlying would be if the index were above the 10% call premium on the call date. In that case, the notes would be called, but the return would be capped at the call premium, he said.

Replicating the notes' payout at maturity, from an investor's perspective, would mean being long two put spreads, he explained.

The first put spread would replicate the digital payout.

"For the digital payout, you're buying a 100-118 put spread. Anywhere between 100 and 118, I get the 118% return," he said.

"In addition to that, you're long the stock. If the stock finishes at 105, the notes will give you 118. You get five from the stock and 13 from the put spread."

The other long put spread position is designed to create the buffer, he said.

"On the downside, if the stock was down to 99, you wouldn't get 118 but 100," he said.

"That means you're long a put spread 100-95, which is your buffer.

"The first put spread knocks out at 100. It's a down-and-out put spread with a European-style barrier, as it's observed at maturity.

"You're also long the 100-95 put spread, which is your buffer.

"And you're long the stocks."

'Fair'

The sellsider said that investors in the notes had to give up something in exchange for the digital return, the uncapped upside and the buffer.

"What you're giving up is any upside beyond the 10% call premium. If you're getting called after one year, you're not going to get anything more than 10% even if the index is up 100%. This operates like a digital. You are short an at-the-money call with a 110 strike," he said.

"Since you have basically no dividends, it helps the structure that you have a very high forward. You also have a cap if the autocall is triggered. Finally you get the downside protection, but 5% is very small."

For investors exposed to an index that has posted a strong bullish performance, there is a potential reversion to the mean. With a buffer of only 5%, a strong index decline would spell hefty losses.

"The index can always go down. But it's not the structure's fault," the sellsider said.

"It's a very interesting structure compared to owning the stocks. To me, it looks pretty fair."

The notes will price in June and settle in July.

BofA Merrill Lynch is the underwriter.

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