A High-Risk, High-Reward Way To Buy Bank Of America

Mar.19.14 | About: Bank of (BAC)


Bank of America Series B warrants offer a highly leveraged way to get long.

Series B warrants are more of a trade than a buy and hold instrument, should rise substantially on a sustained BAC rally.

Way out of the money strike price means the risk of loss is much higher than with Series A warrants, but potential reward is greater.

A couple of weeks ago, I wrote an article in which I made a case for getting long Bank of America (NYSE:BAC) via warrants that are relics of the financial crisis. Specifically, the Series A warrants (BAC-WTA, depending on your broker), which are up more than 15% just since that article was written, and due to several requests from readers, we'll now take a look at the Series B warrants (BAC-WTB, depending on your broker). The Series B warrants are a completely different animal from the A's and as such, I'll be looking at them from a different slant.

The Series B warrants are essentially very long-term call options, similar to the Series A warrants. The Series B expires a few months before the A (October 2018) but the real difference is in the strike price of the warrants. The A has a current strike price of $13.30, meaning it is in the money as of now, but the B's strike price is $30.79, or a whopping 79% higher from today's level. It is due to this that I'm not particularly bullish on these warrants as that is a very long way to go to simply reach the strike price.

The B warrants are currently trading for 93 cents as of this writing so in addition to the stock needing to hit the strike price of $30.79, you actually need a price of $31.72 if you purchase today to break even. You are talking about the stock rising 85% in the next four and a half years to simply break even on this trade. That is a very high bar for shares to reach and despite my bullishness on BAC, there are better ways to get long BAC than the B warrants.

Now, it isn't all doom and gloom for the B's. Like the A warrants, the B's have a provision that reduces the strike price of the warrants when BAC hits a certain dividend threshold. However, unlike the A warrants, the provision is far less favorable for holders. With the A warrants, the strike price is reduced by any dividend that is over one penny per quarter. In essence, the A warrant is adjusted down due to any increase at all in BAC's quarterly dividend. However, the B warrants are only adjusted downward on any amount that is over 32 cents per quarter, meaning that the likelihood of a downward adjustment in the B's is highly unlikely in my view. BAC is currently on pace to earn $1.32 this year so given that a 32 cent quarterly dividend would be $1.28, I don't think we'll see a dividend that large before 2018. I could be wrong but the odds seem stacked against that happening as I would think BAC would need to be earning in the $3.50+ range before it would consider a dividend that large.

Given that the strike price is so far away and that an increased dividend isn't likely to reduce the strike price of the B warrants, I find the A's to be a much better buy. For why I think that is, my previous article is linked above. However, there is still a reason why one could justify getting long the B's instead of the A's. Leverage is much higher in the B's than the A's given that the A's are already well within the money. A's offer more leverage than the common stock but on a much more subdued level. Given that the warrants are roughly half of the stock price they are still a much more leveraged play than simply buying common. However, with the B's so far out of the money, they can provide holders the increased reward, and risk, of owning a very far out of the money option, essentially.

One could buy the B's not to hold forever and eventually exercise, but simply to take advantage of a continued rally in BAC. Given that there is so much time left on the B's before they expire, a sustained rally in BAC shares will send the price of the B's ever higher on greater expectation that it will be in the money by expiration. Thus, by holding the B's you don't necessarily need the stock to reach $31+, you simply need it to move up to make money on the trade. For instance, if we see BAC at $25 in two years, the B warrants will likely be worth much more than 93 cents, as they are today. The price under that scenario is impossible to forecast at this point but as shares get closer to the B strike price, they will become much more attractive to investors. This would be the only reason I'd hold the B warrants; I think the odds of actually being to exercise them in the money at some point are long and that the A's offer a much better risk/reward scenario. But for those more enterprising among us that don't mind the increased chance of loss, the B's may be a good speculative option.

Disclosure: I am long BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.