BofA’s $5.8 million ARNs on SPDR Metals ETF show disappointing timing, terms, contrarian says

By Emma Trincal

New York, June 3 – BofA Finance LLC’s $5.8 million of 0% Accelerated Return Notes due July 28, 2023 linked to the SPDR S&P Metals & Mining ETF combine several shortcomings in terms of valuation of the underlying, upside limitation and risk mitigation, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The payout at maturity will be par of $10 plus triple any ETF gain, subject to a maximum payout of par plus 34%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be exposed to any ETF decline.

Wrong timing

“XME is a very volatile asset. I owned it in the past but not anymore. The price is too high,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments. “XME” is the ticker of the underlying fund.

“It makes sense when you buy it into a recession, when people expect slow economic growth. That’s when it’s cheap. You should buy it when people are gloomy about the economy. Base metals are tied to economic growth. When the economy rebounds, the price goes up.”

Recent fluctuations in the share price show a steep decline between a 52-week high on April 18 and May 12. In less than a month, the ETF dropped 19 points to $47.65, a 28.5% decline. Some analysts attribute the recent downtrend to widespread fears of economic slowdown.

The price however rallied since its drop in the middle of last month, closing at $54.35 on Friday.

Kaplan said the fund’s volatility gives little meaning to short-term trends. His focus is the valuation of the fund’s components, which are the stocks of mining companies. The ETF portfolio is diversified across aluminum, coal, copper, silver, steel and precious metals.

Not cheap

“If you look at a long-term chart, you’ll see that this ETF is quite overvalued,” he said.

Since the March 2020 bottom, the ETF share price has quadrupled.

“This fund has become very popular because people are too much excited about inflation. They’re paying too high a price for companies they think will benefit from rising prices or they’re trying to hedge themselves against inflation or both,” he said.

Kaplan said such reasoning exemplifies the herd mentality of a large number of investors.

Crowded trade

“XME was way below fair value during the original coronavirus bottom in March 2020. That’s when insiders bought it,” he said.

He was referring to the insiders of the mining companies that constitute the ETF holdings.

“In the next two years as the economy was recovering, it went the opposite direction, and the fund became way too expensive. As a result, many insiders this year around April have been selling,” he said.

Kaplan said the ETF is likely to see its price drop later this year.

While two opposite forces may be at play – inflation worries driving up the price and recession fears putting a lid on it – at some point, the market will recognize that the asset is overpriced, he noted.

“It will revert to the mean. There will be more sellers than buyers and the price will drop,” he said.

Looking back, forward

Kaplan contrasted the overpriced base metals with the decline in the price of gold miners.

“Base metals investors look at the review mirror. The news is about inflation, so people get obsessed about it. That’s why XME has been going up a lot. But the inflation trade is done. It’s priced in. It’s already a story of the past,” he said.

The same cannot be said about gold miners.

“Precious metals on the other hand are forward-looking. They price outcomes a year ahead. That’s why GDX went up a lot in the spring and summer of 2020 after the market bottomed,” he said.

GDX is the ticker for the VanEck Gold Miners ETF.

Insiders are selling

With base metals, “the crowd” is still buying without paying any attention to value and fundamentals, he said.

“Insiders are selling the XME as they recognize that the ETF is overvalued.

“Meanwhile, people are pushing the price higher and higher. There’s a huge divergence, which tells me a lot.

“I look at those divergences between experienced investors and emotional investors and obviously I’m more inclined to follow what sophisticated investors are doing. I wouldn’t buy the ETF right now. Insiders know the share price has probably a long way to go down. So, they’re waiting patiently for when the price will be low again. They’re simply responding to the herd, taking the other side.”

A high entry price was not the only factor behind Kaplan’s negative view on the note. The structure itself, he said, had “flaws.”

Limited range

“I don’t like the terms. Why would you have a cap and no protection?” he said.

“It might work if the price goes up by a small percentage, like it’s up 6% and you get 18%. But if it goes up by a large percentage, the cap will come in.”

Once the price rises above 11% over the 14-month period, investors will see their upside limited to the cap, he said.

“If you’re capped out, you won’t be very happy. If the share price is down, you won’t be very happy either.”

For the note to outperform, the price would have to fall between 0% and 11%, he said.

“Only if the price moves within that narrow range does the note make sense,” he said.

Probability game

Investors may have good reasons to believe the share price of the fund would only increase in single-digits. But their bet is speculative, he said.

“Anytime you’re betting on a narrow range of outcomes, you’re needlessly increasing your risk. You want to enhance your chances of winning by tapping on a very wide range of outcomes.

“It’s already difficult enough to guess what’s going to happen, but if you reduce your view to such a narrow range, you’re really limiting your chances of success,” he said.

Protection is a must

The absence of any protection against losses was another big drawback.

“Having no downside protection, no buffer and no barrier is a negative thing. The issuer used all the pricing power to give you three to one on the upside, which is only helpful if the price moves moderately, which may not be the case.

“This is a poorly designed note,” he said.

Kaplan would restructure the notes by adding some downside protection.

“I would put a 30% barrier and no cap. I could do away with the leverage. You don’t need it anyway if you’re bullish. Or I would reduce the leverage maybe to 1.5x or 1.3x, keep the upside uncapped and add some kind of downside protection, whatever would work in terms of pricing.”

The notes are guaranteed by Bank of America Corp.

BofA Securities, Inc. is the underwriter.

The notes settled on Friday.

The Cusip number is 09710F603.

The fee is 1.75%.

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