JPMorgan's 'cliquet' CDs tied to S&P 500: A bet on moderate volatility, risk of no return

By Emma Trincal

New York, Nov. 17 - JPMorgan Chase Bank, NA's capped annual observation certificates of deposits linked to the S&P 500 index fit the needs of investors who believe that the S&P 500 will not be too volatile over the next five years, said a sellsider.

JPMorgan said it plans to price 0% certificates of deposit due Nov. 28, 2014 linked to the S&P 500 index, according to a term sheet. The originality of the offering is its year-over-year calculation method, a structure called "cliquet."

The payout at maturity will be par plus the sum of the index returns for each of the five years making up the life of the CDs, subject to a floor of par.

In each year, the index return will be subject to a cap of at least 11% and the annual percentage change may be negative. The exact cap will be set at pricing.

Harris specialty

"This cliquet structure has been employed a lot by Harris Bank," said a sellsider. "It turns out they weren't in the market this month and JPMorgan was."

Most CDs are structured on a point-to-point basis, this sellsider added. The underlying index return is calculated by comparing its value at the beginning and the end of the term.

Moderate volatility play

With the cliquet structure comes a risk, said the sellsider. In any single year, he said, a decline in the level of the index may offset higher gains in following observation periods, simply because the declines of the index are not limited while the gains are capped, in effect giving index declines greater weight than significant rises of the index.

"You could end up not earning any interest at the end of the five years, even if you have a strong index gain in one year. All it takes is a loss on any given year that will eat up your gain, and it can happen since your gain is capped to 11%," said this sellsider.

"This structure works best if you believe that the index is not going to be very volatile," he said.

The sellsider said that on the other hand, the point-to-point structure is more appropriate for those who believe that the market will be very volatile. "If you think that we're heading for a very big correction in the next two years, then this may not be for you and you might be better off with a one-time calculation on the final date. The point-to-point does not care about the path, while the cliquet is path dependent," he said.

Risking zero interest

The deal's term sheet gave an illustration of such risk.

On the first, second and third years, the annual index return was 20%, which represent a capped periodic return of 11% for each of those years. Then the index would show a 20% loss on the fourth year, followed by the same 20% decline during the last year. From that example, the sum of the periodic returns would be negative at 7%.

Since the sum of the capped periodic returns ends up negative, investors would earn no interest after five years.

Even if only the last year is a bad year after four years in a row of gains, investors may end up with no return at all, said Tony Romero, co-founder and principal at Suncoast Capital Group, a deposit brokerage firm in Miami.

Annual calculation and payment

"What would really make this CD a star would be if the returns were [not just] calculated [but also] paid annually. This may seem overly generous to the investor given the protection he is being afforded with the floor of 0%. However, I feel this can be remedied from the issuer's point of view by perhaps slightly lowering the cap from 11% to say some lesser number," Romero said.

But the sellsider said that while it makes sense, in reality, this solution would not be very practical. "The problem with paying annually is that if you have a down year after several positive years, how do you take it back? Sure you can structure pretty much everything the way you want it, but there is a cost to it," he said.

Two caps

The sellsider noted that CD investors may not have the option of having interests calculated and paid annually. But they may choose between an annual or point-to-point observation method. "In both cases, you don't get the same returns as if you invested directly in the index. That's the cost of principal protection. But the two structures allow you to express two different views and ultimately, it really boils down to your view on the volatility of the index," he said.

And with the different view on volatility come different caps, he added.

A point-to-point structure offered by the same issuer would not offer a cap as high as the one available with a cliquet structure, he said.

"If you had had a point-to-point calculation with this deal, your cap would have been lower than 55% [or five times the current cap.] There is no question that if it was from the same issuer, the cap would be less. That's simply because you're not subject to all of the individual years' ups and downs, so there's a cost for that," the sellsider said.

The CDs are expected to price on Nov. 24 and settle on Nov. 30.

J.P. Morgan Securities Inc. is the agent. Incapital LLC is the distributor.

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