JPMorgan’s $10 million downward shift buffered notes on Euro Stoxx show groundbreaking buffer

By Emma Trincal

New York, April 27 – JPMorgan Chase Financial Co. LLC’s $10 million of 0% uncapped return enhanced notes with a downward-shifted buffer due Oct. 16, 2020 linked to the Euro Stoxx 50 index show a “very neat, very cool structure,” likely designed for a “sophisticated” client eager to get a favorable tax treatment, said a buysider.

The upside payout is standard, sources said. Investors receive 2.2 times the index return.

It’s on the downside that things get a “little more complicated” but “very interesting,” said a market participant.

“It’s a very unusual product. You can replicate it with a bunch of options. But I haven’t seen this type of structure put in a note before.”

The notes do not guarantee any return of principal.

If the index return is less than the initial price by up to 10%, investors will lose one-to-one up to 10% of their principal amount at maturity. In such case the maximum loss is 10%.

If the index falls between 10% and 50%, the payout will be 90% of par. In this scenario investors will lose a fixed 10% amount.

It is only after the index drops more than 50% that investors may lose their entire principal. But the structure remains buffered. If the index falls by more than 50%, investors will lose 10% of principal plus 1.8 times the amount of index decline beyond 50%.

The decks of a ship

“This downside structure is like a cruise ship. You’re much better off on the upper deck than on the lower deck,” said the market participant. He was referring to losses of less than 50% and capped at 10% versus the more drastic situation, in which the index price drops in excess of 50%.

Still even in a catastrophic scenario, losses are significantly buffered, he noted.

For instance, a drop of 60% in the Euro Stoxx 50 will cause investors to lose only 28% of their investment, he added.

Outside the box

An industry source said he did not like the idea of incurring “first losses,” without being buffered first.

“I don’t really want to lose 10%. I’d rather have no losses at all,” he said.

But he admitted that it would be impossible to structure a full principal-protection note with uncapped leveraged upside over a 30-month time horizon.

One of the original aspects of the note was the so-called “downward-shifted buffer.”

“There is a lot of merit to the structure,” said the market participant.

“It’s not the usual profile of protection we talk to investors about.

“But it’s still a buffered note. It’s a 40% buffer that doesn’t kick in until 90.”

The issuer used an unconventional buffer investors may not be used to. But the “downward shift” had its merits, he said.

“You get a pretty nice protection I would say. To me, it’s quite OK to lose 10% if I know that I won’t lose more than 10% unless things get really, really ugly.”

A tax-efficient deal

The buysider said he really liked the notes as they offered a tax efficient protection.

“I believe they did it that way to get the long-term capital gain tax treatment on a pretty defensive structure,” he said.

Notes with principal protection often require investors to pay income taxes every year on the product’s zero-coupon bond holdings even if they don’t receive any payment prior to maturity.

Some dislike principal-protected notes for this sole reason, according to ongoing interviews with several registered investment advisers.

“There are roughly two conditions to meet principal-at-risk definition and therefore benefit from long-term capital gains,” said the buysider.

“The first one is to have a greater than 10% chance of losing at least 10% of your investment. The second is a theoretical chance of losing at least 50%.

“You can see how this is a neat structure. It doesn’t eliminate the losses but it certainly caps the losses...and you can easily qualify for long-term capital tax treatment.”

The tax section of the prospectus confirms that the notes will “generally” be treated as long-term capital gain or loss if held for more than a year.

Upside

The product appears complex but the buysider explained how it was structured with embedded options.

He began with the upside.

The leveraged payout is obtained by buying 2.2 calls at a strike of 100. Any price increase above the strike will bring 2.2 times the index appreciation, he said.

Since no call is sold, the upside is uncapped.

Put spread

On the downside, a put spread will replicate the payout between 90% and 100%, which is a one-to-one exposure.

He gave the following details:

A put is sold at a strike of 100% while another one is bought at a lower strike of 90%.

By shorting the put at 100% investors lose 1% for each 1% of index decline below 100%. But the long position 10 point below stops the losses at the 90% strike. From that point down to zero, the 10% loss will remain.

The put spread strategy, or the purchase and sale of puts at different strikes, is usually used to limit losses. The maximum loss is the difference between the two strikes, which in this case is 10%.

“This put spread gives you a lot of credit which will allow you to buy the calls,” he said.

By “credit” he referred to the net amount of money a put spread remains in the hand of the option investor.

Selling a put at a higher strike brings more premium because it is more risky compared to a lower strike put.

Lower deck

Finally, the last “leg,” or the range between 50% and zero, is built by selling 1.8 puts at a 50% strike. That is how investors begin to lose 1.8 times for each point when the index falls by more than 50%, to which the 10% loss from the put spread is added.

The downside leverage brings the maximum loss to 100% of principal.

“The reason they put the put down at 50% is to qualify for long-term capital gains tax treatment,” the buysider said.

If not, the losses would have remained contained to 10%, which would not qualify the notes for the preferential tax treatment, he added.

Back testing

Aside from the tax strategy, the buysider said the product offered a very attractive risk-adjusted return.

“Your losses are capped at 10% up to 50% down. The upside is uncapped and highly leveraged. It’s a very nice, asymmetrical profile,” he said.

To corroborate his first take on the product, this buysider back tested the notes using 30-month rolling periods, from February 1998 to March 2018.

The results of the back testing analysis showed that the maximum gain over the term was 287.7% versus a maximum loss of 25.5%. On average, investors would have made a 96.4% profit while the loss would have averaged 9.3%. The dispersion between losses and gains was also favorable at about two-third/ one-third or a 66.4% probability of making a profit versus a 33.6% chance of losing money.

“I am definitely going to talk to JPMorgan,” the buysider said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 46647MRG0) priced on April 13.

The fee is 0.75%.

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