JPMorgan introduces short-term principal-protection play with knock-out notes linked to gold

By Emma Trincal

New York, Nov. 22 – JPMorgan Chase Financial Co. LLC’s 0% knock-out notes due Dec. 11, 2020 linked to gold provide capped upside exposure to gold with nearly full principal protection over a short tenor.

Losses are capped at 4%.

An innovative American barrier, referred to as the knock-out, is used to determine the nature of the payout.

The knock-out event will occur if on any day during the life of the notes the commodity closes above 130% of its initial price, according to a 424B2 filing with the Securities and Exchange Commission.

If a knock-out event has not occurred, the payout at maturity will be 96% of par plus the return of the commodity, subject to a floored payout of $960 per $1,000 of notes. This means that the price of gold needs to rise by at least 4% for investors to receive their principal back.

If a knock-out event has occurred, the payout will be $1,170.50 per $1,000 note.

Floored payout

Because the payout for each $1,000 will be a minimum of $960, the actual return on the notes will be the gold price appreciation minus 4%, the prospectus stated.

This leaves the effective fixed payment (when the knock-out occurs) at 13.05%, or the 17.05% cap minus 4%, observed Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments.

This fixed return is available even if gold drops to zero, as long as the knock-out does occur.

When there is no-knock-out, the return to the investor will vary within a range comprised between negative 4% and positive 26%.

The 26% maximum gain represents 30%, the return before knocking out, minus 4%.

Twenty-six percent operates as the actual cap since there cannot be an increase above 30% if there is no knock-out.

The negative 4% maximum loss reflects the principal-protection feature of the note based on the floored payout.

Inventive structure

“Is this complex? Yes. But it’s not a bad deal,” said Kaplan.

“Simplicity is good, but it’s not everything.”

One advantage of the structure for defensive investors is to get a fixed return even if the price of gold falls to zero.

Also, for cautious investors, having the losses capped at 4% is attractive, he said.

“It’s an intelligent structure. It surely is complex, but to be able to get 96% of principal protection over one year with the potential to outperform on the downside requires some ingenuity.”

Not enough upside

However, Kaplan is bullish on gold and said he was not fond of the knock-out scenario.

“I don’t like the idea of gold going up 30% and then being locked in at a lower return,” he said.

“Thirteen percent for a year. That’s not a great return for gold.

“If it happens, if gold is up 30%, you’ll get a better return just riding with it.

“If you’re going to give up 4% no matter what, you should be able to get the full upside.”

He stressed the volatility of gold, acknowledging that the downside protection was the best feature of the product.

But volatility works in both directions.

“You should get a higher payoff, because gold can easily be up 30% in one year. In fact, my view is that it should be,” he said.

Bullish on gold

“I like gold, and I own shares of producers, which is a different sector altogether,” he said.

“But gold in general continues to be unpopular. We’ve seen record outflows from the SPDR Gold Trust ETF lately. Investors don’t like it. It’s a good sign for a contrarian investor.

“And if gold goes up more than 30% in the next year, which I think it will, it will trigger this thing.”

However, for more cautious, less bullish investors, the investment may offer the right balance between upside exposure and downside protection.

“It’s a very volatile asset. It could go down. This note at least takes care of the downside risk,” he said.

“In order to provide the protection, they had to introduce some kind of complexity.

“It’s not a bad note for someone who wants some upside exposure while preserving their capital.”

Conservative play

A market participant said the notes were attractive for investors who lack any clear view on the future direction of gold prices.

“Obviously you’re limiting your loss almost to nothing, and you’re not capping your gains too much. Twenty-six percent is quite high,” he said.

“They could have played with the spread, make it 6% or 2% instead of 4%, depending on your view.

“But the bottom line is that you have a very defensive exposure on a risky asset with a pretty healthy potential return.

“It’s a good trade.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes were scheduled to price on Friday and will settle on Wednesday.

The Cusip number is 48130UST3.

© 2015 Prospect News.
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