Bank of America’s step-up notes linked to S&P 500 offer digital plus no cap for bull plays

By Emma Trincal

New York, July 24 – Bank of America Corp.’s 0% market-linked step-up notes due July 2017 tied to the S&P 500 index enhance investors’ return via a digital payout in a flat or moderately bullish scenario without capping the gains should the market’s performance exceed the digital threshold. This double payout allows various types of bulls to express their views and in some cases to outperform the benchmark, said Tim Vile, structured products analyst at Future Value Consultants.

If the index finishes above the step-up level, 110% to 116% of the initial value, the payout at maturity will be par plus the index return, according to a 424B2 filing with the Securities and Exchange Commission.

Vile said he chose the mid-point value of 113% to generate his research report and score the product.

If the index gains by up to the step-up level, the payout will be par plus the step-up payment of 10% to 16%.

Otherwise, investors will be fully exposed to any losses.

No cap

“This digital product is a little unusual as you’re not penalized by a cap,” he said.

“The majority of digital notes will cap your return at the digital payout. This one pays a minimum return of 13% in a modest growth scenario plus one-to-one above that level.

“The 13% digital is not bad. It’s a 6.5% a year, and that’s a minimum guaranteed return as long as the index has not declined two years from now.

“If it has, however, you’re long the index.

“With a digital call option and the fact that there is no cap above that, the issuer probably did not have any way to finance some sort of barrier or buffer.”

Bullish

The notes are designed for a rather bullish investor, he explained.

While the digital payout, which is delivered in a modestly bullish market, is where investors can really outperform the market, the no-cap feature is typically designed for the more bullish type, he noted.

“The digital provides most of the value of the notes. But this structure was also designed for someone who did not want to be capped if the index turned to rally a lot more than 13%. A less bullish investor may have been more willing to cap the upside above the step level. In exchange for that, he may have been able to raise the step-up or perhaps get a little bit of protection,” he said.

On the other hand, a truly bullish investor would probably prefer a direct long-only exposure to the index.

“If the index is going to be up, what would be the point of buying a note that pays no dividend?” he said.

“This product is a compromise between a pure bullish play on equity and a moderately bullish view on the index.”

Riskmap

Future Value Consultants assesses the risk associated with a product by adding two risk components, market risk and credit risk. The resulting riskmap measures risk on a scale of zero to 10 with 10 as the highest level of risk possible.

The product’s market riskmap is 2.95 versus an average score of 2.84 for digital notes, according to the research firm’s report.

“Market riskmap is a little bit higher. This reflects the absence of any downside protection,” he said.

At 0.57, the credit riskmap is higher than the 0.44 average for the product type.

“Credit risk is higher. It could be due to funding levels slightly higher for Bank of America, although the bank’s credit default swap spreads are quite tight right now,” he noted.

The five-year CDS spreads for Bank of America are at 70 basis points, the same as JPMorgan’s, according to Markit. This compares well with Morgan Stanley (78 bps), Citigroup (79 bps) and Goldman Sachs (88 bps).

“Perhaps the higher credit risk is a result of the two-year tenor. It’s quite possible that this maturity may be a little bit on the longer end compared with the average digital note,” he said.

By adding the two risk components, the research showed a riskmap of 3.51, slightly higher than the average of 3.29 for this product type.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high-and low-volatility environments.

A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios, which in this case is bullish.

The return score is 7.61 versus an average of 7.16 for similar products, the report showed.

“Even though the risk is higher, the non-existence of a cap ups the score,” he said.

“The fact that your return can jump up to a 13% minimum guaranteed even if the index is flat is also a factor.

“Obviously if the risk was lower, the return score would be higher.”

Price, overall scores

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes have a 7.11 price score while the average for the product type is 6.18.

“Since the term is a little bit on the longer end, the fees, which we calculate on an annualized basis, have more time to be amortized compared to similar products,” he said.

“In addition, the issuer appeared to have spent money on the options to make the terms better.

“You have an at-the-money digital call and a call option at 113. All of this has a cost. They spent a fair amount of money on the product. It is reflected by the lack of protection on the downside. There was probably not enough left to price a barrier,” he said.

“The uncapped upside and the digital both make the price score particularly strong. They both add value.”

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The notes showed a 7.36 overall score versus an average score of 6.67 for products of the same type.

“The overall score is very good, much better than average,” he said.

“This is the right type of investment for someone who is bullish and wants to boost returns in a slow growth scenario while eliminating the cap in order to capture a nice, healthy return for two years.”

BofA Merrill Lynch is the agent.

The notes will price in July and settle in August.

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