BofA’s $32.73 million autocallable step-ups linked to Hang Seng offer multiple return outcomes

By Emma Trincal

New York, Sept. 30 – Bank of America Corp.’s $32.73 million of 0% autocallable market-linked step-up notes due Sept. 29, 2017 tied to the Hang Seng China Enterprises index offer investors several attractive opportunities to generate gains, but the volatility of the underlying market amplified by the recent protests in Hong Kong, which have triggered a sell-off, as well as the full downside exposure make the product relatively risky, sources said.

The Hang Seng China Enterprises index is the equity benchmark for the performance of China enterprises listed on the Hong Kong Stock Exchange.

Asian equity markets as well as global markets have seen rising volatility since pro-democracy protests intensified this weekend in Hong Kong.

From Thursday when the notes priced last week to midday in New York on Tuesday, the index lost 3.5%.

The notes offer two ways to reward investors, through the call premium or at maturity.

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 12% if the notes are called on Oct. 2, 2015 or 24% if the notes are called on Sept. 23, 2016.

If the notes are not called, investors at maturity can either receive a digital payout under the form of a step-up payment or the index return with no cap.

If the index finishes above the step-up value, 153% of the initial value, the payout at maturity will be par plus the index return.

If the index return is zero or positive but the index finishes at or below the step-up value, the payout will be par plus the step-up payment of 53%.

Investors will be exposed to any index decline.

Clear exit strategy

“I like the note a lot,” said Dean Zayed, chief executive of Brookstone Capital Management, citing the duration first.

“It’s short-term. Three years is sort of a sweet spot in terms of getting competitive terms but not going too far out in duration,” he said.

Zayed added that he likes autocallable structures in general.

“It provides a clear exit strategy on favorable terms, shortens the note potentially from three years to one or two and pays the client very well for being called,” he said.

Even the timing of the pricing, which occurred just ahead of the sell-off, is not a major drawback in his view.

“The underlying here has clearly been volatile recently given the headlines,” he said.

“This can be taken as a buying opportunity or a signal to avoid China for now. My take is that it probably makes sense to have some exposure to China but to do so through a structured product that can provide very transparent risk/reward terms.”

The structure is bullish only, he noted.

“This note works very well for the client that has a modestly bullish to very bullish view on the index,” he said.

“The step-up feature pays nicely even if there are small gains. This is attractive. Of course you pay for this by accepting no downside protection, so the China bears should stay away from this note.”

Protection missing

But for Tom Balcom, founder of 1650 Wealth Management, the lack of downside protection is “problematic.”

“The idea of course is to get the digital return at maturity because 53% at maturity is 15.23% a year on a compounded basis. But to get this payout, you need the index to be down twice on the first two call dates, two years in a row. How likely is it to happen? If you can forecast that, good for you! It’s the gamble you take here. The best outcome is going to happen only if you’re down on the first two years then up on the last year,” he said.

“You can also get paid with the autocall. The fact that you can collect your premium even if the index is flat as long as it’s not down is a plus. The 12% premium is attractive, especially if you compare it to the performance of the underlying index, which has been pretty flat over the past couple of years.

“So conceptually, this is a good structure. It allows you to participate in the upside with no cap. You can also outperform the index if you get called or if you get the 53% return at the end.

“The problem with this product is the downside. In general, I prefer to have some sort of downside protection. It’s especially important here given the underlying asset class. This is a market with exposure to China. We’re just witnessing protests in Hong Kong, which have hit the global markets.

“The structure sounds good, but the political uncertainty is problematic. I would rather have a cap and get some downside protection.”

Lane Jones, chief investment officer of Evensky & Katz/Foldes Financial Wealth Management, pointed to the risk-reward profile of the notes, saying that the most likely outcome may not offer enough potential gains given the risk taken.

If the notes are called at the end of the first year, investors will get a 12% annualized return. At the end of the second year, the annualized return would be 11.36% on a compounded basis, he said. The step payment represents 15.2% per annum.

Outcomes and probabilities

“Your outcomes are either lose money by being long at maturity if the index declines or get 11.36% or higher,” he said.

“This is obviously a note for someone who is bullish on the Hang Seng. If you thought the index would be down, you wouldn’t own it.”

He said the notes offer four possible positive return scenarios: the first and second observation dates with a possible call premium, the step payment at maturity or the one-to-one index exposure at the end when the index finishes above the step level.

“The likelihood of hitting the 153% level and being long the index with no cap is pretty remote,” he said.

“You’re more likely to get called on year one or year two. To get the long-only upside with no cap, you would have to be down for the past two years and then see the index go up massively in year three.

“The bump up to 53%, or 15.2% annualized, when the index is up anywhere below the 153% threshold is obviously a very good return, but the index would have to be positive after two years of decline.”

Jones concluded that the most desirable scenarios, those occurring at maturity, are the less probable.

Risk versus reward

“If you want to take the long side of the trade, this is a good way to do it,” he said.

“But there is risk built in the trade. If the market is down, you’re down with it. If the market is up, it may be pretty high, and if you’re getting called at 12%, it may not be attractive.

“If you think the market will be very volatile one way or the other, you may not find the deal attractive.

“You’re taking all the downside risk, and the most likely situation is that you’ll get called, which means you’re taking all the risk in exchange for an 11% or 12% return.”

The recent political events in Hong Kong may cause volatility to spike further. The notes priced on Thursday, ahead of the intensification of the protests during the weekend.

“We’ve seen protests in Hong Kong. I don’t know if the product would price better if it priced today. What is certain is that the risk is clearly elevated now given what happened,” he said.

“If you get called, it may not be enough return relative to the risk you’re taking. ... Plus, you’re taking Bank of America’s credit risk.”

BofA Merrill Lynch was the underwriter.

The fee was 2%.

The Cusip number is 06053M526.

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