Merrill Lynch's 8% STEP Income notes tied to Boeing for Svensk attract bulls, income-seekers

By Emma Trincal

New York, Oct. 20 - Merrill Lynch's $42.27 million STEP Income Securities linked to the common stock of Boeing Co. attracted investors bullish on the stock and were priced a week ahead of the company's release of its third-quarter earnings, which was a factor behind the size of the deal, sources said.

The notes priced Oct. 13 on the behalf of AB Svensk Exportkredit.

Boeing released its earnings on Wednesday morning, spurring a post-earnings rally. The share price ended the day 3.25% higher.

"The stock is up, and it's going to be up for the next year and for the next three or four years," said Rick Whittington, analyst at JSA Research, a research firm covering aerospace and defense stocks.

The notes are designed for investors looking for a fixed coupon along with an exposure to the stock, according to the prospectus.

The 8% STEP Income Securities mature Oct. 21, 2011 and pay interest quarterly. They offer a potential additional 3.3% return at maturity if the final share price of Boeing stock is greater than or equal to the step level, which is 108% of the initial share price.

Investors obtain their principal back with no step payment at maturity if the share price ends at or above the threshold value - 95% of the initial level - but below the step level.

Investors will be exposed to any decline in the final share price below the threshold.

Bulls

"We're bullish on the stock. There's a six-year backlog, and Boeing has increased its production," Whittington said.

"The company will see its revenues increase for at least three years. It's one of the best growth stocks."

The product caps the return at the sum of the quarterly interest payments and the step payment, if any, according to the prospectus.

As a result, the maximum return for investors is approximately 11% under the best conditions. That may not bode well for those with a very bullish view, which foresees an increase of the stock price greater than 8% a year from now.

The prospectus warns in its investor considerations section that investors should consider the risk of having their return capped.

Income-seekers

Yet, Whittington said that the product is appropriate for some investors.

"I would think that it's an attractive product. It's appealing to investors who have a different mindset than people buying equity and options. I understand that there's a cap. But I would think it makes sense if you're a fixed-income investor," he said.

The structure of the product could also be a factor behind the success of the deal.

Among offerings that were not exchange-traded notes, the deal was the second largest in size last week after a $43.7 million commodity-linked note offered by Citigroup Funding Inc.

Reverse convertible-like

A sellsider drew a parallel between the note and a reverse convertible. Although the STEP Income Security has a longer maturity than a typical reverse convertible product, provides investors with a return potentially greater than a mere coupon and does not repay investors in stock if the price falls below the threshold, this sellsider said that both structures were very similar.

"It's basically similar to a reverse convertible," he said.

"A reverse convertible would have a slightly different make-up. But the reality is that people like reverse convertibles. They're looking for sources of yield. The downside risk is still there. It's just a slightly different overlay."

Merrill Lynch, Pierce, Fenner & Smith Inc. is the underwriter.

Fees are 1.75%.

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