Bank of America’s step-up notes tied to Euro Stoxx 50, JPX-Nikkei 400 offer mildly bullish bet

By Emma Trincal

New York, Sept. 19 – Bank of America Corp. plans to price 0% market-linked step-up notes due September 2018 linked to a basket composed of the Euro Stoxx 50 index with a 75% weight and the JPX-Nikkei Index 400 with a 25% weight, according to a 424B2 filing with the Securities and Exchange Commission.

If the final basket level is greater than the step-up value, the payout at maturity will be par of $10 plus the basket return. The step-up value is expected to be 118% to 124% of the initial basket level.

If the final basket level is greater than or equal to the initial level but less than or equal to the step-up value, the payout will be par plus the step-up payment, which is expected to be 18% to 24%.

If the final basket level is less than the initial level, investors will have one-to-one exposure to the decline.

Low expectations

“If you don’t expect these two markets to deliver high returns, this is the appropriate product,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“Even if the basket is flat, you get an artificial bump. And if it’s more than the step, I still get the market return. It just has to be flat.”

Ironically, Kunhardt said he is not “a big fan” of the European and Japanese equity markets.

“We’re not particularly optimistic on those markets over the next two years. But we’re asset allocators, and as such, we are going to need international equity.

“Emerging markets with China’s growth slowing and its imports of raw materials declining, these markets are going to be challenged.

“So where else to go? You have to invest in Europe and Japan.”

Not optimistic

Kunhardt said he expects slow growth in Japan because this country “despite years of doubling down on [quantitative easing] is still in decline and has been for more than 30 years.”

Its main problem, he noted, is the aging of its population.

“The demographic trend line of Japan is just awful,” he said.

His vision of Europe is not rosy either.

“The Brexit issues need to be worked out, although it may be minor. You also have the immigration issue weighing down on the economy. Finally the debt crisis has yet to be resolved. They just kick the can down the road about the fiscal issue,” he said.

Necessary bucket

Despite such outlook, Kunhardt said asset allocation requires investing in these markets.

“I don’t expect much growth, but this note could give me 18% to 24% in two years even if there is zero return. This might be the only reason I might probably do it.

“When you’re an asset allocator, you can’t just invest in the U.S. And you’re rolling the dice with anything other than Europe and Japan.

“So this is one of those where I would hold my nose and do it.”

Boost

A market participant said the structure looks attractive. He explained how it may have been priced.

He assumed a dividend yield for the basket of 4%. The Euro Stoxx 50 yields 3%.

He picked a hypothetical step level of 118%.

“At first, if you compare this with what you would get as an equity investor buying the same basket, you would say, It’s the same except that I get an 18% boost from that note between 100 and 118. How can they give you that?

“In reality, you can’t really compare.”

Long put spread

To mimic the return of the notes, the position of the investor would be (a) to buy the stock and (b) to be long a put spread defined as being long a put at a 118 strike and being short another put at 100.

The short put at 100 means that the hypothetical investor would start losing money if the underlying finished below 100.

The long put at 118 indicates that the more the basket price falls below the 118 strike, the greater the value of this option position.

“Of course this is true as long as the price remains at or above the other strike of 100,” he said.

He then explained how the long put spread would give investors a flat “step return” of 18% for any final price comprised between 100 and 118.

For instance at a price of 100, investors would get a value of 100 from their stock position (long the basket) plus 18% from the long put at strike 118. That’s because the value of the long put increases as the basket declines. At 100, the value of the put would then be 18.

Separately, as the price goes up, the value of the basket increases while the long put position decreases, keeping the return constant at 18%. For instance, if the basket price reaches 103, the position is now worth the 103 in equity and 105 from the long put position.

Getting the idea

This example, he noted, is oversimplified because it assumes options with a delta of one, which means that a $1 move in the basket price will automatically translate into a $1 move in the option price. In reality, the delta of an option varies based on the strike prices, the time before expiration and many other factors. In addition, interest rates and correlation between the two basket components would have to also be taken into account along with several other factors.

“But you get the idea on how to mimic this note,” he said.

Spread

The issuer was able to buy the put spread because selling the 100 put helps reduces the cost of buying the 118 put, even though there is still a net cost.

The short put at strike 100 is the equivalent of giving investors full downside exposure, he added.

“It’s always cheaper not to include any downside protection,” he said.

In addition the dividends are not paid to the noteholders but used by the issuer to finance the structure, as it is the case with nearly all equity-linked notes, he said.

At 4% a year, the issuer has 8% available to finance the remaining cost of the spread, based on this market participant’s example.

Trade-off

Investors get the return enhancement offered by the step payment as well as the unlimited upside above that level.

In exchange, they give up dividends and downside protection, he noted.

“It’s a trade-off,” he said.

Investors in the notes would receive 18% in a flat market while the stock investors would not.

On the other end, a slight decline in the basket price would translate into a bigger loss for the noteholders deprived of dividends, while the shareholders might end up with a positive return.

“You can’t really compare the two. This basket and the notes ... these are two different animals.”

BofA Merrill Lynch is the agent.

The notes are expected to price in September and settle in October.

The exact step-up value and step-up payment will be set at pricing.

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