Bank of America (BAC) has had a tough couple of years. The bank has gone from a national powerhouse to basketcase to waking giant - all within 4 years. The troubles at the bank are well known and have been written about more than I can count. That is not what this article is about; we are here to see if there is a potential income investment in the bank.
While the bank's equity undoubtedly has upside from here, it will not be a straight line as they still have some issues to contend with and investor confidence to restore. Income on the equity is a paltry 0.48% and will continue to be low until they can get their capital plan fully approved and show that increasing the dividend will not strain their capital building efforts. Preferreds are a great option and the bank has them across all of their subsidiaries. The preferred alternative is enticing, and I will be addressing the preferred complex and level in the capital structure at another date.
This review is focused on their debt, specifically their $25 par "baby" bonds. I have chosen these bonds due to the fact that they are exchange traded and price discovery is much easier for the non-institutional investor.
Our options in the BAC $25 per exchange traded debt market are:
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Performance
The year-to-date chart (courtesy of Yahoo!) of the notes shows the strong performance the notes have had so far in 2012:
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The year-to-date price performance of each series has been varied, with the 5.50%s IKL leading the complex up 9.2% and the 6.50%s IKJ bringing up the rear at 5.16%.
| Ticker | YTD Performance | 1 Yr Performance | ||||||||||||||||||
| IKL | 9.62% | 0.41% | ||||||||||||||||||
| IKM | 7.91% | -0.08% | ||||||||||||||||||
| IKJ | 5.16% | 0.28% | ||||||||||||||||||
| IKR | 5.55% | -0.16% | ||||||||||||||||||
While the IKJs have underperformed YTD relative to their peers (potentially due to their premium price), their performance shouldn't be as far behind as they are. This naturally attracts me to these notes.
Valuation
The relative value versus peers:
| Note | Yield | Spread/30s |
| Bank of America 5 1/2% Sub Notes 2033 | 5.61% | 249bps |
| Bank of America 5 7/8% Sub Notes 2033 | 6.01% | 289bps |
| Bank of America 6 1/2% Sub Notes 2032 | 6.48% | 336bps |
| Bank of America 6% Sub Notes 3034 | 6.11% | 299bps |
| Citigroup 6.625% due 6/2032 | 300bps | |
| Wells Fargo 5.50% due 8/2035 | 205bps |
Within the BAC internote bonds, the yield and spread advantage clearly rests with the 6.50% sub notes. As the 6.50% sub notes have a shorter maturity (and duration) than the rest of the sub notes, and all issues are currently callable, the Bank of America 6 1/2% sub notes 2032 are currently the best investment option for investors looking for income from Bank of America bonds. The 2032s are also cheap to Citigroup (C) 2032s and obviously (with good reason) cheap to Wells Fargo (WFC) 2035s.
Investment Risks
There is no such thing as a free lunch the saying goes and the same is true with these exchange traded Bank of America notes. The following are the primary risks of investing in these notes:
- Interest rate (duration) risk: These are longer dated bonds, and as such they will be particularly sensitive to a change in interest rates. While treasury rates could head marginally lower, the highest probability scenario calls for higher rates. While substantially higher rates may not occur in the next couple of months, I have no doubt they are headed our way. As rates climb, the prices of these notes (all traditional bonds) must fall in order to increase the yield to market rates.
- Credit risk: Bank of America is not out of the woods yet, and there may be more woods beyond the current woods which creates the possibility that Bank of America's risk (real or perceived) increases and investors demand more to take this risk. This shows up in requiring a higher spread to the risk free rates which pushes prices down.
Description of Notes
A brief description of each note is as follows (please note that all internotes are governed by the following prospectus, the details of the specific notes are governed by the prospectus supplements):
All notes contain a survivor option, which states:
The notes contain a provision that requires BAC, upon request by the authorized representative of the beneficial owner of the notes, to repay those notes prior to maturity following the death of the beneficial owner of the notes, so long as the notes were acquired by the deceased beneficial owner at least six months prior to the request. This feature is referred to as the Survivor's Option.
BAC 5.50% Subordinated InterNotes due July 15, 2033 (IKL)
Deal Size: $125,000,000
Rating: Baa2/BBB+
Callable: Currently
Survivor Option: Yes
BAC 5 7/8% Subordinated InterNotes due Dec. 15, 2033 (IKM)
Deal Size: $157,500,000
Rating: Baa2/BBB+
Callable: Currently
Survivor Option: Yes
BAC 6.50% Subordinated InterNotes due Oct. 15, 2032 (IKJ)
Deal Size: $224,000,000
Rating: Baa2/BBB+
Callable: Currently
Survivor Option: Yes
BAC 6.00% Subordinated InterNotes due Aug. 15, 2034 (IKR)
Deal Size: $137,500,000
Rating: Baa2/BBB+
Callable: Currently
Survivor Option: Yes
Bottom Line: The Bank of America InterNotes make sense for an investor that can withstand price declines in the event of rising rates (a "when", not "if") or believes that Bank of America debt should tighten as their business prospects recover and they put more of their issues behind them. Of the four InterNotes, I believe that the BAC 6.50% Subordinated InterNotes due Oct. 15, 2032 (IKJ) have the most value as they have not rallied as much as the others and offer more yield with less interest rate (duration) risk.
Disclosure: I am long BAC.
