JPMorgan’s buffered notes linked to three indexes make for a ‘creative’ worst-of, source says

By Emma Trincal

New York, Aug. 18 – Worst-of notes are not always attractive to advisers, but JPMorgan Chase & Co.’s 0% uncapped buffered equity notes due Aug. 2, 2018 linked to three U.S. equity indexes are an exception, buysiders said, commenting on a recently priced issue.

The payout is linked to the least performing of the S&P 500 index, the Russell 2000 index and the Dow Jones industrial average, according to a 424B2 filing with the Securities and Exchange Commission.

If each index finishes at or above its initial level, the payout at maturity will be par plus the return of the least-performing index.

If any index finishes below its initial value but the least-performing index does not finish below its initial value by more than 32%, the payout will be par.

If any index falls by more than 32%, investors will lose 1% for each 1% decline of the least-performing index beyond the 32% buffer.

Real buffer

“This is the first time I have seen a worst-of with a true buffer,” said Dean Zayed, chief executive of Brookstone Capital Management.

“Given the six-year bull market and the recent sideways action we have seen, it is a huge advantage to have a real buffer as opposed to a barrier. Clients that are weary of equities will appreciate this protection.”

Steven Foldes, vice chairman at Evensky & Katz/Foldes Financial Wealth Management, said that he likes the notes.

“It’s a very interesting note, a very creative one in terms of worst-of. The idea of a worst-of by definition is not attractive, but this one has interesting characteristics,” he said.

Correlation

The first one is the high correlation among the three underlying indexes.

“You’re getting exposure to the worst-performing index, but you’re dealing with three U.S. equity indexes which are fairly correlated to each other. Each of the three have a higher than 0.83 correlation with each other.

“This relatively high correlation is a key component to why the notes are attractive. If you’re dealing with highly negatively correlated asset classes or benchmarks, you don’t know what you will get. Put together U.S. stocks and commodities for instance. That’s a lot more risk.

“This one is different.”

The correlation coefficient between the Dow and the S&P 500, the two U.S. large-cap benchmarks, is 0.95, according to Morningstar, he noted. Even when compared to the Russell 2000, which tracks small-cap stocks, the Dow shows a 0.83 correlation coefficient, and the S&P 500 index a 0.86 correlation.

In a worst-of note, the more correlated to each other the underliers are, the lesser the risk as the chances of one among the three moving in a different direction than the others is lower, he explained.

“It’s not to say you can’t have differentials in performance. For instance, last year – a great year for U.S. stocks – the Dow Jones gained 10%, the S&P 13% and the Russell under 5%. But the idea is that over three years, the performances of each index shouldn’t be too dissimilar.”

Brookstone’s Zayed agreed, saying that having correlation helps offset some of the risks seen with worst-of payouts.

“These three indices are fairly well correlated, with the Russell 2000 being the one that could potentially behave substantially differently,” he said.

“But relative to other indexes, take the Shanghai index for instance ... the Russell is not a dangerously volatile index. This should bring some comfort to investors ... knowing that the index which could potentially behave badly is not highly volatile.”

No cap

The second attractive characteristic of the product, according to Foldes, is the downside protection.

“You get a 32% protection over three years, which is substantial. And it’s a buffer, not a barrier,” Foldes said.

“So if you want to bearish, this is a very defensive structure.

“But what’s interesting is that you can be bearish and bullish too.”

The absence of any cap is another reason to find the structure interesting.

“There is no leverage, but the fact that there is uncapped exposure allows you to get the full benefit of the upside,” he said.

“This notion of a substantial downside protection with no cap on the upside is very attractive. Clients can be bearish and somewhat bullish too. It’s a little bit of having their cake and eating it too.

“This note has universal attractiveness.”

Tenor

Even the three-year term, which is “a little longer than we typically like,” was not seen as a drawback given the creditworthiness of the issuer and the “low” level of fees, he said.

“I’m guessing that the notes were sold to a registered investment adviser. We’ll probably investigate further for ourselves.”

The notes (Cusip: 48125UD58) priced July 30 and settled on Aug. 4.

The size was $752,000.

J.P. Morgan Securities LLC was the agent.

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