BofA’s $4.77 million digital barrier notes linked to S&P, Russell 2000 offer worst-of, no cap

By Emma Trincal

New York, Jan. 30 – BofA Finance LLC’s $4.77 million of 0% digital plus barrier notes due Jan. 31, 2022 linked to the Russell 2000 index and the S&P 500 index offer a new version of Bank of America’s traditional market-linked step-up notes by introducing a worst-of payout, which allowed the issuer to enhance the terms. The main appeal of the structure is to keep the upside uncapped above the digital return.

The notes are guaranteed by Bank of America Corp., according to a 424B2 filing with the Securities and Exchange Commission.

If the final level of the lesser-performing index is greater than or equal to its initial level, the payout at maturity will be par plus the greater of the lesser-performing index’s return and 68%.

If the final level of the lesser-performing index is less than its initial level but greater than or equal to its threshold level, 70% of its initial level, the payout will be par.

If the final level of the lesser-performing index is less than its threshold level, investors will be exposed to the decline of the lesser-performing index from its initial level.

Great return

“That’s a pretty good return, and you have a 30% downside protection. I don’t think you’re going to need the downside, but if they’re going to give it to you, take it!” a portfolio manager said.

“The digital return is really good I think because you’re not going to get that kind of growth out of the market.”

Bank of America consistently sells similar notes under the label “market-linked step-up notes.” Those deals can reach large sizes. These products, as with this one, offer a digital return that does not cap investors’ returns on the upside, a feature that contributes to their popularity, according to data compiled by Prospect News, which records large block deals. Most of the step-up notes tend to be shorter in duration, they can be autocallable, and investors tend to be fully exposed to the downside, according to a review of past deals.

Correlation

The note recently priced is different from the traditional equity step-up model in several ways: it is longer than the average, and it is not linked to a single asset. Both the length and the worst-of helped the pricing of a barrier on the downside and perhaps enabled the issuer to increase the coupon, sources said.

Worst-of features introduce additional risk associated with the inverse correlation of the underlying assets, which in turn helps provide better terms, such as the inclusion of a barrier or the increase of the coupon size.

But this portfolio manager said such risk is limited.

“I don’t see that taking the worst-performing one is going to make such a difference. There is a little bit more risk of course, but it’s not significant. Although the two indices are constructed with different constituents, they’re both very broad-based. ... They have a global macro exposure to them.”

But some more conservative buysiders are not totally comfortable with the worst-of.

“It’s a little too exotic for us,” one financial adviser said.

“It’s not easy to explain to a client. You’re talking about two different indexes. It’s hard to make predictions over five years also.

“We’re a little bit more conservative. We prefer shorter terms ... leveraged notes with a buffer. We don’t use a lot of leverage, just a little bit, and we offer single-digit returns, but we do get the buffers.”

The pros

Steven Foldes, vice-chairman at Evensky & Katz/Foldes Financial Wealth Management, has a mixed view.

“Conceptually, I like these kinds of notes. I like to have a digital as a minimum return with no cap,” he said.

“The fact that it is a worst of is always problematic unless the two asset classes have a fairly high correlation to each other. The S&P and the Russell fit that description. They certainly have that correlation. These two are good.”

Bank of America’s credit is “getting better,” he added.

But he pointed to other aspects of the structure he does not like as much.

“Five years is way too long to us. We wouldn’t be interested in that.”

The 68% minimum return over the five-year period appears attractive. But Foldes always takes into account the amount of dividends the noteholder will have to forgo when he analyzes a product.

Such amount, which is an opportunity cost, gets bigger with longer-dated products.

The Russell 2000 has a 1.38% dividend yield. On a compounded basis, investors are not receiving 7.1% worth of dividends on a compounded basis, he said.

The dividend yield on the S&P 500 is 2.03%. Investors must give up 10.6% over the period, he added.

If the worst of is the Russell 2000, which would be the “best-case scenario” in terms of unpaid dividends, investors would have to give up 7%, he said.

Two alternatives

Foldes said the 70% threshold level is perhaps not necessary and therefore would be expensive.

“The uncapped is favorable. The booster – I get 68% even if I’m up one basis point – is favorable,” he said.

But once their return is higher than the digital, investors will still not get as much as a long-only investor because of the dividends, he noted.

“You’re uncapped, and that’s great. But you’re underperforming the index because of the dividends.”

On the other hand, Foldes said that the 30% contingent downside protection is “unlikely” to be of use over a five-year period.

For this reason, if he wanted to purchase the notes, he would re-engineer the notes in one or two ways.

The first scenario would be to increase the digital payout and eliminate the downside protection, keeping everything else the same.

The second option would be to lower the level that triggers the minimum payout below the initial price. This would allow investors to generate alpha by getting the “booster” even if the reference asset finishes negative as long as it does not drop below the barrier level. By the same token, the process would reduce the amount of protection.

“Let’s assume the index is down 15%. I get my coupon. This would make the product very attractive.”

Again, the upside would remain uncapped above the digital level. However, Foldes understands that he would not be able to get the same 68% return.

“It would be less, but I could outperform on the downside.”

No cap value

Although Foldes sees pros and cons about the product, the maturity is one of his biggest objections.

However, for a client seeking that long-term exposure, terms could be negotiable.

“I would suspect a better way to do it would be having a higher digital with no downside protection or a lower coupon but one you could get at a negative level,” he said.

“What’s really attractive about this product is the uncapped. I wouldn’t want to touch that.”

Foldes added that he has become very familiar with those uncapped digital notes because he has found that leveraged buffered notes are no longer appealing given low volatility levels.

“We used to have very high caps, very large buffers nine or 10 years ago. For instance, at the time we bought a two-year, two-time leverage, cap at 80% on REITs with a 20% downside protection.

“Back in the days, you had real opportunities to outperform.

“Leveraged buffered deals don’t give you anything near that anymore.”

Caps in particular have become much too low, he said.

BofA Merrill Lynch was the agent.

The notes (Cusip: 09709TAD3) priced on Wednesday.

The fee was 2%.

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