JPMorgan’s $489,000 dual directional notes on S&P 500, Russell offer rare buffer with a twist

By Emma Trincal

New York, Sept. 5 – JPMorgan Chase Financial Co. LLC’s $489,000 of uncapped dual directional buffered return enhanced notes due Aug. 30, 2024 linked to the lesser performing of the S&P 500 index and the Russell 2000 index offer a solution to the challenge issuers face when trying to add a buffer to an absolute return payout. And the solution is: cutting the 100% inverse participation by half.

If either index declines, but not more than 20%, investors will receive 50% of the absolute value of the index return of the lesser performing index, according to a 424B2 filing with the Securities and Exchange Commission.

Beyond the buffer, investors will lose 1% for each 1% of the worst performer’s decline.

The structure gives the issuer enough in “option budget” to be able to price a bit of leverage without having to cap the upside.

The payout at maturity will be par plus 1.04 times the lesser performing index return if both indexes finish above their initial values.

While tolerating 50% in absolute return participation for the benefit of a large buffer may be an easy sale, advisers were more reluctant to hold the note for five years.

Insufficient leverage

For Steve Doucette, financial adviser at Proctor Financial, the long maturity may not even be necessary.

“You’re locking yourself in five year out for this buffer, but do you really need a 20% buffer over five years?” he asked.

“The leverage isn’t very much. You’re only outperforming 4% over five years.

“Why would you want to lock yourself in for that? I guess it’s because you really want this absolute return component.”

But the imbalance between the downside, which provides potential alpha and the upside which adds nearly nothing compared to a fund was hard to justify.

“It’s good to have the absolute return. But it’s mostly good if you’re slightly bearish. If you’re not, you’re sacrificing too much in leverage,” he said.

Restructuring the note

Doucette would reconsider the trade-off, agreeing to lower the buffer for more leverage.

“I guess the question would be: how much do you have to reduce the buffer in order to get some real leverage on the upside if you still wanted to try to maintain that absolute return component?” he said.

No one really wants to cut a hard buffer. But in this case, Doucette found two justifications in addition to his attempt at raising the leverage.

“Of course, you never know if you’re not going to need a 20% buffer. But statistically, the odds of a 20% drop over a five-year period are pretty low,” he said.

Another reason was where the current market cycle is.

“Ten years of this bull run...there’s going to be a bear market and probably soon. But we know that bear markets are short-lived. They last 10 months on average. That reduces the probabilities of a big drop after five years.

“If it was a three-year I might want to stick with the buffer.”

Price return

Jeff Pietsch, head of capital markets at the Institute for Wealth Management, also pointed to the long duration as a possible drawback.

“The loss of dividends over five years is substantial,” he said.

Assuming a dividend yield of approximately 2%, investors would incur an opportunity cost of 10%, he added.

“You get a 4% kicker from the leverage, which covers two years of dividends. You still have three years missing, or 6%. That’s 6% less than the total return of the index.”

“One really good thing is there is no cap.”

Five years

Forecasting what the market will be like at maturity was difficult, which was another reason to be uncomfortable with the tenor.

“Five years is so long,” he said.

The notes would benefit investors in most down markets. If prices drop less than 20%, they get the absolute return. If the drop exceeds the buffer size, they would still outperform despite the non-payment of dividends, he noted.

“But it’s hard to be bearish over five years. Even if we are at the end of the bull cycle now, we may have enough time for a recovery. Over five years, we’re still expecting returns in the single-digits simply because stocks’ CAPE ratios are so high.”

The CAPE ratio is a measure of price-per-earnings ratio based on average inflation-adjusted earnings from the previous 10 years.

A good fit for some

Another concern was the 4.08% fee, as disclosed in the filing.

“That’s really expensive,” he said.

The notes however could be used by certain investors.

“For someone going into retirement, it’s a good way to participate in the upside while mitigating some of the risk.

“In this uncertain environment and despite the high cost of the product, I can see this being interesting for a certain type of investor, including a retail investor, one with a conservative profile.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48132CL84) settled Aug. 30.

The fee is 4.08001%.

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