Bank of America’s five-year Mitts tied to Euro Stoxx 50 offer alternative to straight debt

By Emma Trincal

New York, Nov. 3 – BofA Finance LLC’s 0% Market Index Target-Term Securities due November 2022 linked to the Euro Stoxx 50 index offer an alternative to conventional bond investing, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par of $10 plus any index gain, up to a maximum return of 45% to 55%. The exact cap will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls, the payout will be par.

Tough to price

“This is a product for conservative investors who want full protection against a market downturn. It’s always a good idea to compare those notes to the equivalent corporate paper and see if you’re comfortable getting a return that’s not guaranteed but potentially higher,” she said.

Principal-protected notes which combine a zero-coupon bond with options have been on the decline in recent years.

Volume for these products in the U.S. is down 67% this year to $210 million from $645 million last year, according to data compiled by Prospect News. Ten years before, the notional was closer to $2.35 billion.

“We used to have capital guaranteed notes a lot more in the older days of higher interest rates. Now, because the zero-coupon is such a big part of the product, there isn’t much left to spend on the options.

The low interest rate environment has made those structures difficult to put together and as a result principal-protected notes are “less attractive-sounding” than they used to be, she noted.

Due diligence

Investors considering a principal-protected note should compare them with a conventional interest bearing debt instrument from the same issuer.

Credit risk and duration are the same. But investors in the structured note do not receive periodic interest payments.

“However you have the ability to earn much more than what you would get paid with a bond. This note doesn’t pay a fixed rate but in theory you can get up to 10% a year depending on the index,” she said.

“Your main risk is if the market is down. In that case you end up not losing but gaining nothing after five years.”

For investors looking for full principal-protection but not in need of periodic income, the tradeoff may make sense, if they are willing to take that risk.

Product specific tests

Future Value Consultants produces stress tests for structured notes to help clients make that kind of decision, she said.

Each report contains 29 tables or tests, showing the distribution of probabilities between all possible outcomes.

One of those tables, called product specific tests, provides probabilities for both the best and the worst outcome, which are getting the cap or par only.

The firm uses five market assumptions, which are – neutral, bullish, bearish, low volatility and high volatility.

To run the report, Hampson selected the midpoint of the range for the cap or 150%.

In a bullish market scenario, investors will get the maximum return 27% of the time.

But 36% of the time, they will only get their principal back. This last scenario reflects a flat or negative market performance.

The bull market scenario is not based on an aggressive assumption, she noted, pointing to a 4.2% rate of return used by the model for the Euro Stoxx 50 index.

It is part of the firm’s methodology, which uses very conservative growth assumptions in each of the market scenarios.

Getting something

Getting nothing and getting the maximum return are not the only two outcomes with this product. There is a 37% probability to have “an in-between” outcome in which investors get a positive return below the cap, she said.

When adding the two positive outcomes, investors are nearly two-thirds of the time likely to realize a gain.

The probability of losing principal as a result of a market downturn is zero by virtue of the full protection.

Average payoff

While this distribution of outcome seems very advantageous to investors, the average payoffs simulated by the firm’s model are less compelling.

This should not come as a surprise.

“Putting together the principal protection is very expensive. There is only so much you can spend on options to raise the cap,” she said.

The capital performance tests reveal that investors getting more than par at maturity will average a 34.6% gain. That’s approximately 6% a year on a compounded basis. This simulation is for the bull scenario.

Key metric

Perhaps more actionable is the average payoff figure displayed in the simulated overall statistics, which reveals the average payoff regardless of the outcome for the same bull assumption. This time investors can expect an annual average compounded return of 4.07%.

“This is for everything that can happen including receiving par only at maturity. It’s the number you want to look at when comparing this product to a bond,” she said.

Hampson did not comment on current bond pricing. But Bank of America’s five-year corporate bonds are now showing yields slightly lower than 3%. The five-year Treasury note yields 2%.

“If you can find a corporate paper that pays more than 4%, you’d be better off with the bond,” she said.

Alternative

Ultimately investors will base their decision on other factors than just yield.

“Some people are drawn to conventional bonds because they need a fixed coupon rather than variable return even if it means they might get a potentially lower rate.

The risk in investing in those principal-protected notes is to get no coupon or a lower coupon than what an equivalent bond from the same issuer may offer.

Compared to an equity investment the cap may also limit the potential return.

“But it’s an alternative for investors who want some return from the market without taking the risk of losing their initial investment,” she said.

“Our stress tests help them decide what’s the best option for them.”

The notes will be guaranteed by Bank of America Corp.

BofA Merrill Lynch is the agent.

The notes will price and settle in November.

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