JPMorgan plans unusual ‘shark’ note with bear tilt, leveraged absolute return on S&P 500

By Emma Trincal

New York, June 12 – JPMorgan Chase Financial Co. LLC’s 0% bearish knock-out notes due June 18, 2020 linked to the S&P 500 index offer a variety of noteworthy features wrapped up in a lesser-known structure called “shark fin” named after the shape of the product’s payout diagram.

Shark fin notes offer principal protection typically over a shorter period of time. They also allow for participation in the underlying before it reaches a certain level called knock-out. When that’s the case the positive return is either significantly limited to a fixed return called a rebate or eliminated altogether, leaving investors with their initial capital but no gains.

If the index ends below its initial level but at or above the knock-out level of 79.75% of its initial level, the JPMorgan note will pay at maturity par plus 200% of the absolute value of the index return, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise the payout will be par.

Because this note is bearish, gains are limited on the downside to a band of 20.25 percentage points from initial price to the knock-out level. The leveraged absolute return participation is unusual, sources noted. It does not increase the range of positive outcome but it pushes up the potential gains to a 40.5% cap.

Heroes

“You don’t gain anything in being bullish here. It’s a bear note. But it’s not to be used as a directional bet.

I would definitely employ it as a pure hedge,” said Tom Balcom, founder at 1650 Wealth Management.

He stressed the advantage of the note versus the use of an exchange-traded fund.

“If you buy an inverse leveraged ETF and the market is up, you lose money. If it’s two-times, you lose twice as fast. With that, you get your principal back. That’s the whole point.”

Investors get protection on the downside as well for any drop in the index beyond 20%. He pointed to the benefits of this payout.

“The market is down 10%. You get par. I don’t think anyone is going to be upset about it.

“It’s down 30%. You get your money back. You’re a hero to your client!

Investing in the notes in an effort to get the maximum return was not necessarily what the note was designed to accomplish.

“You’re not buying it for the participation really trying to hit home run. This is to be used as a hedge,” he said.

Tax burden

One downside of the structure will be the tax treatment, Balcom noted.

As most principal-protected notes, which are built around a zero-coupon bond, investors have to pay income tax each year even though profits are not received until maturity. This is because they get taxed each year on the original issue discount (OID) of the zero, according to an assumption cited in the prospectus.

“The OID can be an issue. But it can also be easily offset by your gains,” he said.

“As a hedge, it makes a lot of sense. It’s an efficient risk mitigating strategy and it’s short term.”

Down-and-out

Bullish shark notes, which allow for gains when the index rises above a positive knock-out level, employ an up-and-out call. The name of the options means that it no longer exists when the knock-out level is hit.

In this case, the structure is based on a down-and-out put, a market participant said. If the price falls beyond the knock-out level, the leveraged participation disappears.

“It’s a kind of payoff that obviously tries to protect someone against shallow losses in the S&P,” he said.

This market participant however was skeptical about the structure from a practical standpoint.

“These shark notes, they optically look like they pay a lot. This one gives you two times. But you have to hit a low level to make it, otherwise you’re not getting anything.”

As an example, a 2% decline in the index would only generate a 4% return, he said. The index would have to drop near bear territory without breaching the knock-out level in order for investors to maximize their gains. Such a level on the edge of what is defined as a bear market (20% decline or more) limits the odds of a strong return. The market can be neither bullish or bearish, he said.

Weak frequency

Since a loss scenario is not possible unless a credit event impacts the issuer’s ability to repay investors, the worst-case scenario would be full return of principal with no gains, he continued.

This outcome occurs in all scenarios including a drop in the index from 79.75% to 0% as well as any possible flat or positive index performance, limiting the success of the strategy to the 20% decline below initial price.

“You always have to think of your probabilities to win or lose,” he said.

“This one doesn’t offer a wide frequency of wins.

“Optically it looks good. But investors could easily be disappointed.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price on Wednesday and settle on June 18.

The Cusip number is 48129M2G0.

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