JPMorgan’s buffered notes due 2018 linked to S&P 500 are designed for risk-averse investors

By Emma Trincal

New York, July 18 – JPMorgan Chase & Co.’s 0% capped buffered equity notes due July 27, 2018 linked to the S&P 500 index aim at outperforming the market on the downside and may represent a good alternative to cash for investors worried about a correction, said Tim Mortimer, managing director at Future Value Consultants.

The payout at maturity will be par plus any gain in the index, up to a maximum return of at least 40%. Investors will receive par if the index falls by up to 20% and will lose 1% for every 1% that the index declines beyond 20%, according to an FWP filing with the Securities and Exchange Commission.

“You’ve got one-for-one on the upside, 40% cap, which is less than 9% a year, and a 20% buffer. It scores quite well in terms of value and return, according to our model. And yet, all you have here is basically the buffer,” he said.

But a buffer “is a lot more” than a barrier, he noted.

“Between 80 and 100, you get your principal back in this one and your loss is only on the excess beyond the buffer,” he said.

“On the upside, most people would be happy with a 40% return.”

Strong protection

Investors have to forego the S&P 500 index’s 2% dividend yield, which represents an opportunity cost of 8% compared to a direct equity investment, he noted.

“At first sight, this product doesn’t look exciting,” he said.

“No dividends, no leverage, plus a cap. You know that you’re not going to outperform on the upside.

“However, it may be a good trade-off on the downside because ... the buffer is large enough to enable you to beat the index even without the dividends.”

If at maturity the index were to decline by more than 8%, the notes would outperform on the downside.

“Below 92% you’re outperforming the S&P on the way down,” he said.

“It can naturally be used as a hedge, especially with the S&P 500 index recording new highs, leading many to fear that the market is headed for a correction soon. A lot of people are concerned about the downside risk.

“On the upside, you just track the index. You give up the portion beyond 140%.”

As the note offers more appeal on the downside than on the upside, investors in the product would tend to be conservative, he said.

Risk averse

“You have to be someone who needs to be long the S&P, but you also have to be pretty risk-averse. This is a low-risk structure. It’s designed to protect the investment against losses,” he said.

“The cap is quite tight. It’s less than 9% a year. It’s not an awful lot. We see more people trying to buy notes with higher caps or no caps lately, and this is definitely not the case here.

“The investor in the notes needs the market exposure, wants some upside and is prepared to take some downside risk but some limited downside risk. The notes would be for someone who is sufficiently risk-averse or someone who would have sufficiently modest expectations on the index to find value in a 20% buffer that’s designed to reduce losses quite substantially.

“Since you’re not getting much more than the downside protection, this is really for an investor who sees a lot of value in the buffer. This is a buffer that’s supposed to compensate you for everything else.”

Alternative to cash

The notes’ value could be measured against equity returns or against cash, he said, adding that the benefit is much more palpable when compared to risk-free assets, using a hypothetical cash investment with a 0.5% annual yield.

“If you compare this with a certificate of deposit paying half of a percent a year, you’re getting the potential for a 9% upside, which you could never get from cash. That’s a real trade-off, a more substantial one than comparing it to equity where you know that you’re already losing 2% in dividends and capping your gains at less than 9% a year. If you compare it with a cash investment, you have a much lower opportunity cost,” he said.

While the appeal is less obvious on the downside since the notes, unlike cash, are a principal-at-risk investment, overall Mortimer said that the product is a good alternative to cash.

“You don’t have the same risk profile of course. But still, you have protection all the way down to 80. That’s a lot,” he said.

“It’s definitely better against cash returns than equity returns.”

Low risk

In its research, Future Value Consultants assesses risk, return and price using a variety of proprietary scores in order to compare a product to others. The firm’s model compares each product to two different averages: same product type and all products recently issued. The notes fall into the “unleveraged return” category.

The categorization enables the research firm to compare the product to products of the same structure type when assigning scores.

The risk associated with a structured note is measured by Future Value Consultants’ riskmap. The rating on a scale of zero to 10 measures the risk with 10 being the highest level of risk. The riskmap is obtained by adding its two sub-components: market risk and credit risk.

“The market risk is quite a bit less than the average of the product type and a lot less than all products,” he said.

The market riskmap for the notes is 1.62 versus an average score of 1.96 for products of the same type, according to the report. For the all-product sample, the average market riskmap is 3.35.

On the credit risk scale, the notes have a higher score, 0.81, than the 0.58 average score for the category.

“The higher credit risk is mostly due to the four-year term, a bit longer than average. It’s the duration factor that’s at play here rather than the creditworthiness of the issuer,” he said.

The five-year credit default swap spreads for JPMorgan are 57 basis points, according to Markit. This issuer shows tighter spreads than Citigroup (67 bps), Morgan Stanley and Bank of America (both at 69 bps) and Goldman Sachs (75 bps).

Risk-adjusted return

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. The return score is calculated based on the best among the five return scenarios, which for this particular product would be the bullish scenario.

The return score for the notes is 7.91, compared with an average of 7.39 for the same product type. It is also higher than the average for all products at 6.96.

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the best assumptions.

The bullish scenario shows a 31% probability for a zero to 5% annualized product return and a 56.8% chance of getting a return in the 5% to 10% bucket. With the cap at 9%, the probability would apply to the 5% to 9% portion of the bucket.

On the downside, the odds of losing money are 12.2%, according to the report.

Price, overall scores

Future Value Consultants measures value with its price score on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The product has an 8.61 price score versus 7.57 for the average of its peers.

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is simply the average of the price score and the return score.

The product, which has an overall score of 8.26, surpasses the average for the same product type of 7.48 and shows an even stronger profile than all products, which show an average 6.83 overall score.

“Both return score and price score are above average,” Mortimer said.

“For the price score, it’s because the fee amount is low compared to the average.

“The return score is high too. The chances of a bad outcome are low, and even if there is a loss, the buffer by essence will cut the amount of losses by one fifth.

“On the upside, you can still get a good outcome, although you won’t beat the benchmark.

“It looks like an extremely solid product.”

The notes (Cusip: 48127DST6) are expected to price on Thursday and settle July 29.

J.P. Morgan Securities LLC is the agent.

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