Bank of America’s $5 million digital return notes on 30-year CMS rate show unusual risk-reward

By Emma Trincal

New York, July 1 – Bank of America Corp.’s $5 million of 0% digital return notes due July 3, 2017 linked to the 30-year Constant Maturity Swap rate have an intriguing structure that combines a rate underlier with terms more often seen in equity-linked notes.

For many buysiders and asset allocators who tend to show their clients either pure equity or pure fixed-income products, the payout and risk-reward associated with the product are confusing if not unappealing.

“This is a fixed-income play but with equity-like return characteristics, in particular, a risk-return profile that does not necessarily work in your favor,” said Tom Balcom, founder of 1650 Wealth Management.

If the 30-year CMS rate finishes at or above the 4.515% upper reference rate, the payout at maturity will be par plus the digital return of 21.1%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the rate finishes at or above its initial rate but below the upper reference rate.

Otherwise, the payout will be $800 per $1,000 principal amount.

The 30-year CMS rate was 3.315% at pricing on Thursday, according to the prospectus.

Not a bond

For Balcom, the notes lack the advantages of bonds.

“It doesn’t strike me as a good risk reward,” he said.

“If for some reason interest rates decline slightly for whatever reason, you lose money.

“If they drop by one basis point, you lose 20% of your principal.”

Not only would such decline be “drastic” he said, but investors would fail to get the diversification benefits bonds offer.

“A decline in interest rate would probably go hand in hand with an economic slowdown, so you would lose money elsewhere in your portfolio. That defeats the purpose of holding bonds,” he said.

“We use bonds as a risk hedging tool. It’s nice to make 20% if rates go up and if that’s your bet. But I wouldn’t be willing to lose 20% of my money if my thesis was wrong.”

The digital payout of the structure works both ways, on the upside and on the downside. Balcom said that the “downside digital” is problematic.

“This deal is tied to rates, but the structure is even more risky than most equity deals,” he said.

“You don’t have any buffer or barrier. For sure if you lose, the losses are limited to 20% of your investment. You could see it as a cap on the downside, except that it takes almost nothing to trigger that 20% loss.”

The notes simply do not fit his definition of a fixed-income investment, he said.

“With bonds we don’t like to take too much additional risk,” he said.

“We prefer to go with boring investment-grade bonds. They are not yielding great these days, but there is a reason they are in our portfolio.”

Head scratcher

Donald McCoy, financial adviser at Planners Financial Services, said that he does not understand the risk-reward profile of the notes.

“I’m not quite sure who they’re trying to appeal to. Obviously, they have someone in mind; otherwise, they wouldn’t do it,” he said.

“If you risk 20% to make 20%, if this is the trade-off, I would probably not do this. That’s a head scratcher.”

Not compelling

Tony Romero, co-founder and managing partner at Suncoast Capital Group, said that the notes do not offer an attractive risk-adjusted return.

“To boil it down into its simplest terms, if at maturity the 30-year CMS rate is less than what it is today, then the buyer is out 20% of their principal as well as the opportunity cost of interest,” he said.

“If the CMS rate is above the initial level but below 4.51%, then the investor will receive back her principal but will not have earned any interest over three years.

“Finally, if the CMS rate is above the 4.51% threshold, the buyer reaps a bonanza of nearly 7% per annum.”

One risk factor is that investors have to “guess” what interest rates will be in three years.

“The only CMS level that matters is that at maturity. The yield curve may steepen or flatten as it will during the term, and it would be all for naught. In effect, not only must one speculate correctly on the shape of the yield curve, but one must also time it just so, which of course is a fool’s errand,” he said.

Romero said that he could not think of any “compelling reason” to buy this security.

“You in effect are capped at a 7% return per annum with a floor of negative 6.66% per annum. Perhaps people smarter than me can accurately forecast the yield curve three years forward, but in my view, it is pure speculation – a roll of the dice, if you will,” he said.

Safer alternatives are available to investors, he said.

“There are far simpler ways to bet on the direction of interest rates. For example, there are ETFs and leveraged ETFs both standard and inverse that allow one to speculate on interest rates at various points on the yield curve while maintaining liquidity,” he said.

It’s a rate deal

A structurer said that the deal’s unusual appearance is perhaps not that significant. To be sure, the structure is uncommon as it borrows the digital payout most often seen with equity.

“It is a rate deal. It’s a digital. You risk 20% to get 20%. It’s almost like a fair shot,” the structurer said.

“If you get above the higher rate, you win. If you don’t, you lose. There are actually three possible payouts. Either you get 120, 100 or 80. There are only three outcomes.

“It’s a rate deal, but they’re using a digital structure, so it’s treated almost like equity. They’re treating the underlying rate almost like a stock.”

He meant that the structure is different from a CMS spread deal or a CMS spread range accrual note.

In a typical CMS spread or leveraged CMS spread deal, investors get a fixed rate in the first year. After that, their rate becomes variable, depending on the spread between two different rates on the curve. The two spreads commonly used are the 30-year CMS rate minus the five-year CMS rate or the 30-year CMS rate minus the two-year CMS rate. The spread is sometimes leveraged by a factor often ranging from two to five.

The range accrual feature introduces an equity index underlying that will be used to compute the number of days during which the coupon can be offered, hence potentially reducing its amount. This ratio will be the proportion of days on which the index’s closing level is greater than a predetermined barrier level.

Those CMS spreads are bets on the shape of the curve, the structurer explained, because should the curve be inverted the spread would be negative, which would cancel out the coupon.

“This product behaves very differently, even though the underlying is a CMS rate,” he said.

“You have a lot of rate deals tied to Libor, and they often apply a day count.

“Then you have the CMS spreads. These CMS spreads are a bet on the curve shape. Here, it’s more of a direct bet on the level of the rates rather than the shape.”

But those differences are not essential, he said.

A digital world

“Other than that, it’s not different from those yield curve deals. Those are digital as well. They’re digital on the spread, while here you have a digital on the actual rate,” he said.

He meant that when a spread is negative, investors will have no coupon.

“Those CMS spread deals are digital. If the spread is positive, you get a coupon. If it’s not, you get nothing,” he explained.

The prospect of losing 20% of principal from the activation of a digital option appears frightening to most buysiders, but this structurer put the downside risk in perspective.

“Compare this with a 20-year CMS and imagine not getting any coupon for 20 years,” he said.

“Here your risk is to lose 20% of your money, but your loss is capped and you know it in advance. Besides, this is only three years. Three years is a big difference compared to 20.

“Compare this risk with a 20-year note that may or may not pay 3% a year. Say you only get one year of interest. You’ve lost 19 years out of 20, which is a 57% return.

“Here it’s a 20% risk, but you’re only invested for three years. These are two different risks, and in reality, if you look at the big picture, none of the risks is worse than the other.”

BofA Merrill Lynch was the underwriter.

The notes (Cusip: 06048WPP9) had a 1.75% fee.

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