By CHUCK JAFFE
After some of his bond investments matured, Chris in Seattle considered what to do next. His broker pitched him an idea that Chris -- who describes himself as someone "who actually reads the paperwork" -- felt was "too good to be true."
Chris's understanding was that the investment -- Market Linked Step-Up Notes linked to the Standard & Poor's 500-stock index and issued by Bank of America Corp. -- would deliver great returns if the market was flat or up modestly, capture the return if the market goes gangbusters, and protect against loss if the market gets hammered. Even the fees looked low to him.
While he wrote me thinking there had to be a catch, he invested $20,000 into the three-year notes. Thankfully, that was less than 10% of the money he was rolling over -- savings he has earmarked for his 10-year-old's college education -- because Market-Linked Step-Up Notes are the Stupid Investment of the Week.
Stupid Investment of the Week highlights the conditions and characteristics that make securities less than ideal for the average investor, and is written in the hope that spotlighting one troublesome situation ill make it easier to sidestep similar dangers elsewhere. While obviously not a purchase recommendation, the column is not intended to be a sell signal.
That's particularly so with these market-linked notes, which have no liquidity and no secondary market. Whether the purchase was a good one or not, the best thing Chris and others like him can do now is ride it out.
That said, what Chris understood from the sales pitch and what he actually purchased are not quite the same. That's part of the problem, because even a guy who reads the paperwork can have a tough time getting through the 157-page term sheet and understanding pages of hypothetical outcomes.
That's true even in a case like this, where I can say that Bank of America's (BAC)
In investment language, the market-linked notes from BofA are three-year unsecured, subordinated debt securities, built to deliver at least a 26.75% gain over three years if the S&P 500 is up over that time period, while protecting against losses of up to 15%.
Here's how it works:
If the S&P 500 is positive up to 26.75% cumulatively over three years, the buyer pockets a flat 26.75% return. If the index gains more than that over three years, the buyer gets the full appreciation minus dividends.
If the index is down up to 15% cumulatively over the three years, investors get their initial investment back. But if the market loses more, the investor loses with it, so if the index drops 25%, the investor suffers a 10% loss (every percentage point beyond the 15% protection level).
That sounds pretty good, but the devil is in the details; even when they are presented as clearly as BofA's offer sheet.
Consider that Chris thought he was protected against a decline of up to 85%. In fact, he was putting that percentage of his investment at risk.
In exchange for downside protection, investors give up liquidity and dividends on the index. Plus, they're exposed to the credit risk of BofA, as the issuer of the notes. Bank of America officials confirmed that this is how the S&P-linked note works, but would not discuss the product on the record.
Whether that is a lot of risk really depends on how someone feels about the market -- and Bank of America.
Currently, the dividend yield on the S&P 500 is around 2%. That's important because dividends are de-facto protection against the market's downside. Where the BofA note offers a 15% downside cushion, investors should recognize that they would get the first six points of that protection --- the dividend yield on the index over the three-year holding period -- just holding a S&P 500 index fund.
Likewise, while the step-up value is in the range of 8% compounded over three years, the investor would get the same thing if the index gained 6% plus the dividend.
It's also worth noting that the underwriting discount -- the fee the investor pays off the top -- amounts to 22.5 cents on every $10 unit. Chris mistakenly thought this would be cheaper than an index fund. At 2.25%, however, even spread out over three years it's roughly four times more expensive than a solid S&P index fund.
And that's a lot of the problem with this kind of structured note, because average investors think of an equity product when they're buying a debt security.
Based on its current debt ratings -- on negative review for a possible downgrade -- Bank of America senior unsecured debt would be giving a competitive investment-grade bond yield of somewhere in the 3.5% to 4.5% range. So assume you could get a 4% annualized return simply buying a corporate bond and letting it compound for three years.
So if the market falls between 0% and 15% over the three years you own the BofA notes -- meaning you get your money back -- you have given up the 12% return you could have had from a bond with similar credit risk.
If the index falls more than 15%, you've lost the fixed return of the bond -- and you gave up that dividend on the S&P 500 -- either of which would have protected you nearly as well as the step-up note.
If the index is flat or up as much as 26.75%, the corporate bond route would leave you behind by about 14% (the difference between the step-up value and the bond's return). If the market exceeds the step-up gains, you're ahead by the excess return, minus the missing dividends.
In fact, if you think the market is going to do that well, you'd be better off buying the index fund and skipping the downside protection.
Ironically, this product is best when the market is flat. But that's not what Chris is expecting.
"Effectively, over the three years, you're conceding your bond return in down years, and your dividend return in extreme up or down years, in exchange for getting an extra kicker of about 10.5% [over three years] if the markets are relatively flat," said Michael Kitces of Pinnacle Advisory Group in Maryland.
"The comparisons can be really hard to wrap one's brain around, though," he added, "because you're simultaneously dealing with the stock returns you could get as an alternative, and the bond returns you 'should' get just for taking the bond risk of BAC."
Said Chris: "I don't think it's a bad product -- it's not like I am going to lose a lot of money with this -- but I guess it's not as good for me as it sounded when I first heard about it."
That, ultimately, is the problem with a lot of structured products, and why investors like Chris need to have all of their questions answered completely before making a purchase.