BofA’s Mitts tied to Euro Stoxx have nearly full protection, but watch the delta, source says

By Emma Trincal

New York, Nov. 25 – Bank of America Corp.’s 0% Market Index Target-Term Securities due November 2018 linked to the Euro Stoxx 50 index do not offer 100% principal protection but a close 90%, said sources debating over the attractiveness of the three-year tenor.

If the index return is positive, the payout at maturity will be par of $10 plus the index return, subject to a maximum return of 18% to 28% that will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the index is negative, the payout will be par plus the return with a minimum payout of 90% of par.

90% versus 100%

“It’s a nice bullish play on Europe. Three years is relatively short for nearly a full protection,” an industry source said.

“But it’s not totally surprising. You still have 10% at risk, and believe it or not, 10% versus zero makes a big difference in terms of pricing.

“With that 10% you can shorten the duration. You have more room to play with the options.”

He also noted that the structure offers no leverage on the upside and a relatively modest cap.

The 18% to 28% cap range corresponds to a 4.22% to 6.37% annualized compounded return.

In addition, the issuer was able to use the 3.25% dividend yield of the Euro Stoxx 50, which offers an additional 1.25 percentage points over the S&P 500 index.

Risk-reward

A market participant, however, said that three years is too long given the type of structure.

“It doesn’t look too appealing,” this market participant said.

“The cap range – 18% to 28% – is out of scope. I would never put more than 4% in a range, otherwise you don’t know what you’re buying.”

In order to gain anywhere between 18% and 28%, an investors has to be willing to lose 10%, he said, summarizing the risk-return profile, which he found of little appeal.

But his main concern was the three-year tenor, which he considered to be long-term.

“Any long-term capital-guaranteed product with a cap can be problematic due to the delta of the embedded options,” he said.

Delta measures the price movement of an option in response to the change in price of the underlying security.

Moving parts

He “deconstructed” the notes as follows: The deal represents a long bond position for the one-to-one participation. Second, a long call with a 90% strike mimics the first 10% losses. Finally, a short call with a strike between 118% and 128% reflects the cap above which ends the participation. He chose a 121% cap in a hypothetical scenario.

Based on the strikes levels, the term and the underlier, he said that the 90 strike has a delta of about 60%.

“It’s a gut feeling,” he said, adding that the pricing was only for illustrative purposes.

A delta of 60%, or 0.6, means that a one-point increase in the index will cause the option price to rise by 60%, or 0.6.

For the short 121 call (or short call position with a strike of 121%), he assumed the following: “The delta is negative because it’s a short call, so maybe it’s negative 25%.”

A delta will be positive on a long call or short put, both bullish strategies. In reverse, delta is negative on a long put and short call, both bearish positions.

The deltas can be added to get the net delta, which in this example would be a net delta of 35%, or 60% minus 25%.

Market up

He pursued his hypothetical analysis, running two different market price increase scenarios.

In the first one, the index gains 10%.

The delta of the long call will rise, he said ,giving as an example an increase from 60% to 66%.

That’s because the further an option gets in the money, the more its delta will increase.

“But the short call delta increases faster because as the index goes up, the short call position loses value.”

He assumed that the short call delta would then change from negative 25% to negative 40%.

Adding the two new deltas – positive 66% and negative 40%, gives a net delta of 26%, which is less than the 35% net delta in the first scenario.

Up more

In a second scenario, the assumption is the index jumping 21% to the short call strike.

“The long call delta will increase to 75%, for instance, and the short call may increase even more to negative 50%,” he said.

“The short call was out of the money and is now at the money, so the delta is even more negative.”

Investors selling calls are betting that the price will not rise above the strike price of the call. Inversely, call buyers hope to see the price exceed the strike. If the price hits the 121 strike, the option is said to be in the money, which means that the value of the short call drops.

With a short call delta of negative 50% and a long call delta of positive 75%, the net delta is now positive 25%.

Stiff delta

“An increase to 121% will lower my net delta. My participation is less,” he concluded.

“The problem is essentially that your net delta decreases when the market price goes up.

“You also have time-dependency. You’d be better off with the same note, same protection but with a shorter duration even if it means a lower cap.

“Long-term capital-guaranteed products with caps can be problematic. You get a very stiff delta. It gives you a slowly reacting product.”

He said he would prefer a “shark note,” which he described as follows: “Take a nine-month maturity. You can even add more protection, for instance, I would take a 95% protection.

“I would keep my 121% cap. I get one-to-one up to the 121 level. If the market overshoots, if I go beyond the cap, I lose my maximum ... I lose 5% of my capital.

“I risk only 5%. I get some participation. I don’t wait for three years. It’s only nine months.”

Some like it short

Three years may not be a big deal for all investors, he conceded.

“It depends on who your client is.

“Some clients are happy with a three-year term. If you’re talking to an institution or a pension, they’ll take the product for three years. They have no problem sleeping on it, and they’ll tell you, ‘let’s see what happens in 2018.’

“But for a private client who gets a quarterly report and sees that after only one year, the index is up 25% while he can only get 21% and only at maturity, that’s a different story. He may want to sell thinking the market is toppish. But he can’t.

Merrill Lynch & Co. is the agent.

The notes will price in November and settle in December.

The fee is 2%.

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