JPMorgan’s $1 million uncapped digital barrier notes on MSCI Emerging Markets seen as too long

By Emma Trincal

New York, Aug. 28 – JPMorgan Chase Financial Co. LLC’s $1 million of 0% uncapped digital barrier notes due Aug. 23, 2029 linked to the MSCI Emerging Markets index offer a minimum guaranteed return with no cap and a deep barrier on the downside. But advisers were unimpressed by the digital return and the long holding period.

If the index ends at or above its initial level, the payout at maturity will be par plus the greater of the index return and 53.5%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines but finishes at or above its 50% barrier and lose 1% for every 1% that the index declines if it finishes below the barrier.

“I wouldn’t do it. The asset class is too volatile,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

Underperformer

Most studies showing the emerging markets outperforming the U.S. or Europe tend to point to a specific country, he added.

“If you’re going to cherry pick returns by countries, you’ll always find one that outperforms the others. There are plenty of country-specific ETFs. But how do you know in advance which countries are going to outperform? You don’t. Nobody does,” he said.

As a group, emerging markets have been underperforming domestic markets for more than a decade. A comparison of the total returns of the iShares MSCI Emerging Markets ETF with the SPDR S&P 500 ETF trust showed that since 2013 emerging markets have only outperformed the U.S. once, in 2017, according to data from Morningstar.

Volatility

The standard deviation of emerging markets as an asset class is elevated, noted Kunhardt, saying it’s in the higher 20’s while the U.S. is around 18.

“There is a much higher variance, therefore much more risk, since that’s how we measure risk. You end up with less return for more risk,” he said.

“This is one of the reasons a lot of asset allocators underweight emerging markets. I hardly have any.”

His own asset allocation to emerging markets is less than 1%, he noted.

But his greatest criticism was the long duration of the notes.

“I wouldn’t be buying a note on this asset class even with a 50% barrier especially if I have to hold it for six years. I wouldn’t want a six-year note on domestic markets, let alone on emerging markets,” he said.

Low digital

Steven Foldes, wealth manager and founder of Evensky & Katz / Foldes Financial Wealth Management, also disliked the holding period.

“It’s a very long-term note. We like the credit of JPMorgan, one of the best if not the best among U.S. banks. But six years for us is way too long. That duration would be a non-starter,” he said.

The upside payout was not satisfying either.

“It’s nice to have a minimum return but the one you’re getting here is not great. We’re talking about 7.5% a year compounded plus you’re giving up the dividends,” he said.

The index carries a 2% dividend yield.

Far East

However, this adviser said he liked the underlying index.

“Emerging markets have been a very underwhelming asset class,” he said.

A lot of this had to do with the index’s high concentration on a few countries, he explained. The index is overweight China, which probably contributed to drag the return, he added.

Four countries make for nearly three quarters of the index, he noted, citing China (30%); Taiwan (15%); India (15%) and South Korea (12).

“This is almost a Far East index...that’s what you’re betting on,” he said.

50% barrier

Foldes had a positive outlook on emerging markets, however.

“They are very much undervalued relative to the U.S. and even relative to developed markets. I do believe we will see a much better performance. You have to take advantage of those cheap valuations. Getting a coupon-like return is not the way to go,” he said.

“It’s good to have uncapped gains, but it’s not enough. I would want to replace the digital with some leverage,” he said.

The barrier on the downside was unreasonably large in his view.

“I can’t see how you would need a 50% protection over a six-year period even with a volatile asset class like emerging markets,” he said.

The chances of breaching the barrier over six years were likely to be very small statistically speaking, he added.

Reconstructing the note

“I would want to pick up some of the option money spent on this barrier and replace it with a modest buffer, maybe a 10% buffer. In addition, I would convert this barrier into a levered upside,” he said.

A lower fee would help improve pricing, he noted.

“It’s a very expensive note.”

The fee is 3.35%, according to the prospectus.

Growth preferred

Some advisers may have wished to see a higher guaranteed return instead of some leverage. But Foldes was not one of them.

“I am not looking for a coupon. If I get exposure to emerging markets, it’s because I’m hoping to see some level of outperformance,” he said.

“I do believe that China will get its act together and that emerging markets in general are going to come back. I see some recovery ahead. This is why I would rather get uncapped levered upside instead of a minimum return,” he said.

Foldes’ main objection was that the structure of the note did not offer the opportunity to profit from a likely recovery in emerging markets. But the structure had other flaws.

“It’s an expensive note. The large barrier is unnecessary. Six years is way too long, and you’re giving up a lot of dividends.

“It would not be something we would consider,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes settled on Aug. 23.

The Cusip number is 48133YX33.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.