Bank of America's 8% STEP notes tied to Toll Brothers offer income, but risk reward disappoints

By Emma Trincal

New York, July 16 - Bank of America Corp.'s 8% STEP Income Securities due August 2014 linked to the common stock of Toll Brothers, Inc. offer a fixed coupon, the potential for additional income and some slight downside protection, but sources said that the notes may not appeal to income-seeking investors, who tend to be risk-averse or at least would seek a higher coupon for the risk associated with the product.

The 8% interest rate will be payable quarterly, according to an FWP filing with the Securities and Exchange Commission.

If the final price of Toll Brothers stock is greater than or equal to the step level, the payout at maturity will be par of $10 plus the step payment. The step level will be 108% of the initial share price. The step payment is expected to be 1% to 5% and will be set at pricing.

If the final share price is greater than or equal to the threshold level, 95% of the initial share price, but less than the step level, investors will receive par.

If the final share price is less than the threshold level, investors will lose 1% for every 1% that the price declines below the threshold level.

Toll Brothers is a homebuilder whose stock's implied volatility is slightly less than 40%. The share price has gained 5% year to date, but it has been moving sharply up and down in short periods of time, sources noted. For instance, the stock gained 22.5% between April 18 and May 22 and fell 16% from May 23 to July 5.

The company designs, builds, markets and arranges financing for single-family homes in luxury residential communities.

The wrong stock

For Dean Zayed, chief executive of Brookstone Capital Management, the upside offered by the notes was not sufficient given the risk incurred.

The most an investor could gain from the notes, assuming a 3% step payment, would be the 8% coupon and the step payment, which caps the upside at 11%, he said.

On the downside, however, the 5% buffer leaves 95% of the principal at risk minus the coupon, which puts investors in the position of risking 87% of their principal, he said.

"Since Toll Brothers is a barometer on the housing market, you would have to have a lot of confidence that the housing recovery will continue over the next year in order to participate in this," Zayed said.

"We usually segment our clients between those who seek income and those who seek growth. This deal is for income. But they're taking a tremendous amount of risk for an inadequate level of income. It's a fairly risky play.

"If their goal is income, then this is the wrong product for them.

"You get an 8% coupon plus potentially 3% more. That's not much in this environment.

"The housing recovery looks good, but who knows what it will be like in a year? Things appear to be positive, but given the weakness of the recovery, it will take time before housing gets real momentum again.

"It's also the wrong stock to use.

"With a stock that volatile, you should either have a much higher coupon or a much better buffer because Toll Brothers could go anywhere.

"In addition, giving you a 1% to 5% range for the additional coupon doesn't help in assessing pricing.

"I don't think they'll print much of that particular deal, honestly. The terms are not attractive."

Others said that the notes offer an advantage compared to stock ownership by reducing risk. But the cost for the protection is high and paid for with less upside.

Flattening the middle

Jonathan Tiemann, president of Tiemann Investment Advisors, LLC, distinguished the two types of returns paid by the issuer: the fixed interest rate of 8% and the contingent 3% coupon delivered via the step payment.

"On the upside, except for the step payment, selling a call option for 8% ... That's about an even trade. The current price is $34. A one-year call with a strike at $37 gives you 2.5. So you're in the neighborhood of that 8% return," he said.

He obtained a 7.35% return by dividing the 2.5 premium received by the current price.

"This part you could do that yourself," he said.

"Then they sweeten it a little bit with the buffer and the step payment, but they're also flattening out your return from the price of 95 to 108. Anywhere between those two strikes, you're not getting anything more than your coupon. I suppose that's how they pay for it.

"Overall, you're sort of doing two things. You're selling off the upside for the coupon, and you're flattening out the middle to get the little step income plus the buffer, neither one of them is really big.

"It's a little bit less risky than holding the stock, but your upside is really small."

Other risks

One could reduce the market risk by adding the coupon to the buffer, he said.

But investors are still exposed to other types of risk, which are specific to structured notes, he added.

"Is it an income play? I guess if you're really that desperate for income. But in a way, as soon as you begin to think of this as an 8% coupon, you're potentially lost in the weeds," he said.

"Always keep in the back of your mind that there is the additional issue of having no liquidity, plus you take the credit risk.

"What you're doing is you're turning your upside into current income and getting a little bit of help on the downside.

"It's a little bit less risky than holding the stock outright.

"The attractive part is that you get that 8% coupon.

"The less attractive part is that you still have most of the downside and your upside is gone.

"That's the problem. And that's the problem I have in general with a buy-write."

A "buy-write" is an option strategy in which an investor buys or owns a stock and sells a call on it for the same notional as a way to generate income or use the income as a downside cushion.

BofA Merrill Lynch is the agent.

The notes are expected to price in July and settle in August.

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