JPMorgan's CDs tied to index basket give global, protected exposure, but cost seen as high

By Emma Trincal

New York, Feb. 2 - JPMorgan Chase Bank, NA's planned certificates of deposit linked to a global hybrid index basket give investors the advantage of getting exposed to emerging markets while enjoying principal protection. But the structure is not cheap, sources said.

The 0% CDs will mature Feb. 26, 2016, according to a term sheet.

The equally weighted basket includes the MSCI World index, the Dow Jones - UBS Commodity index and the JPMorgan GBI Global Bond Index Total Return hedged in dollars.

The payout at maturity will be par plus at least 100% of any basket gain, with the exact participation rate to be set at pricing. Investors will receive at least par.

The final basket level will equal the average of its closing levels on Feb. 23 of each year during the life of the CDs beginning in 2011.

Even asset allocation

The CDs are designed for investors who seek exposure to any appreciation of an equally weighted and diversified basket composed of the three global indexes, according to the term sheet. The asset allocation is evenly divided between stocks, commodities and bonds as the underlying basket is the sum of a global stock index, a commodity benchmark and a global bond index.

In addition, investors benefit from the Federal Deposit Insurance Corp.'s insurance up to the legal limits.

Positive points

"There are some positive points in this offering," said Tony Romero, co-founder and managing partner at Suncoast Capital Group, a deposit brokerage firm in Coral Gables, Fla.

"Of course the fact that it is FDIC insured guarantees that no principal is at risk provided the CD is held to maturity. In addition, the participation rate will not be less than 100%, and the term sheet seemed to imply that it may well be over 100%. Finally, one has the ability to speculate, albeit in an inefficient way, on equity-, commodity- and bond-based indexes without actually risking one's principal."

Romero said the investment is "inefficient" because the fees associated with the structure are in his opinion "too high."

The cost

The term sheet disclosed that approximately $65.40 per $1,000 CD is paid to JPMorgan and its affiliates. Out of this, $38.85 is given to dealers as selling concessions.

"Being in the CD business for over 20 years, I am quite familiar with typical margins on various types of CDs from bullets, callables, step-ups and simple index-based CDs. These margins typically range from $1.00 per $1,000 of principal to perhaps as much as $15.00 for longer-term callable or step-up CDs," Romero said.

"I have never seen, even for step-ups, callable, anything in excess of $20.00 per $1,000 at the most for a five-year. Here, you're paying $65.00 per $1,000. It's huge."

No free lunch

But a sellsider not involved in the deal disagreed.

"Plain vanilla CDs are a totally different story. You can't compare apple and oranges," he said.

"There's no option in bullet CDs. It's a simple structure. You charge two bucks for it," he added.

This sellsider said that compensation has to be measured in reference to the risk undertaken by the issuer.

"JPMorgan is taking about $26.00 out of $65.00. Is that so much for taking the risk on their books? You have to hedge those products. The issuer is taking a risk for six years on their books. It's not like booking a back-to-back swap and you're done. They have to hedge that on a daily basis. Unless you get a perfect hedge, the traders have to take the risk and manage that risk at all times."

Finally, this sellsider pointed to JPMorgan's disclosure standards when bringing CDs to the market.

"JPMorgan is very transparent in the way they do their documentation. Other issuers may not do that, especially for CD term sheets," he said.

Yearly averaging

Another issue with the structure, Romero said, is the calculation mode of the basket performance.

Rather than comparing the underlying basket level at maturity with its initial value - a commonly used method called "point-to-point" - the structurer averages out each yearly performance, according to the term sheet.

"Returns may be deteriorated by the method of calculating them," said Romero. "Averaging returns over the length of the CD may negate any benefit from any significant volatility or appreciation in the index, especially in the latter portion of the term," he noted.

"If you have one year that's really bad, it will bring down everything," Romero added.

Currency risk/opportunity

Finally, investors are subject to currency risk, said Romero.

Some of the components underlying the basket are foreign securities, and their price has to be converted into dollars in order to measure the basket performance, according to the term sheet.

"In addition to the above, the investor is also faced with currency risk since all basket indices are converted to U.S. dollars," said Romero.

This risk, however, could also be an opportunity.

As the term sheet clearly disclosed, investors will be "adversely affected" and "the payment at maturity may be reduced" if the dollar strengthens against the currencies in which the foreign securities are denominated.

But investors would benefit from the opposite scenario: If the same currencies appreciate against the dollar, investors will gain from the conversion into dollars.

The CDs are expected to price Feb. 23 and settle Feb. 26.

J.P. Morgan Securities Inc. is the agent.

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