Deutsche, JPMorgan plan similar deals tied to index, but difference seen in issuer credit risk

By Kenneth Lim

Boston, Nov. 12 - A couple of similar accelerated notes linked to the S&P MidCap 400 index are mostly differentiated by the issuers' default risks, a structured products analyst said.

J.P. Morgan Securities LLC is distributing both deals, although one is issued by Deutsche Bank AG, London Branch and the other by JPMorgan Chase & Co.

Almost all of the terms on both deals are the same. Both 0% buffered return enhanced notes mature on Dec. 1, 2011.

At maturity, investors of both products will receive double the underlying index's positive return, subject to a maximum total return on the notes of at least 13.5%. The exact return cap was to be set at pricing.

If the index ends below 90% of its initial value, investors lose 1.1111% of the principal for every 1% that the index is below 90%. Investors receive par if the index ends between 90% and 100% of its initial value.

Besides the issuer, the main difference lies in how the final value of the index is calculated. For the Deutsche Bank notes, the ending index level is taken as the five-day average close of the index just before maturity. For the JPMorgan-issued notes, the ending index level is the closing index level on Nov. 28, 2011.

Slight differences

With the terms of the notes almost the same, the products received relatively similar scores from Future Value Consultants.

The Deutsche Bank notes got an overall rating of 7.44 out of a best possible 10 and a "riskmap" score of 3.22 out of a riskiest possible 10. The JPMorgan notes got an overall rating of 7.48 and a riskmap of 3.17.

The slight difference in the scores was mostly a reflection of Future Value Consultants' assessment of issuer risk, said analyst Suzi Hampson.

"We've got Deutsche Bank with a slightly higher credit risk in [credit default swaps] than JPMorgan, so I would think the difference in the riskmap is due to that," Hampson said.

The Deutsche Bank product's use of averaging to calculate the index's final value should lower the volatility of the expected return, which means that investors could be disadvantaged if the index is rising consistently over the final few days. But the lower return volatility also protects investors from sharp drops in the index near to maturity.

"That's the intention I think," Hampson said. "If the index is sort of growing in the last six months or some, it would impact the return but also dampen the impact of last-minute falls in the index, which would affect the volatility of returns."

But a five-day average does not offer significant risk mitigation for investors, Hampson reckoned.

"You wouldn't really expect it to," she said. "It's just five days compared to one day. And especially in a year's time, it's very small."

Higher volatility boosts cap

Overall, the products offer the typical risk-and-reward considerations for accelerated growth investments.

Investors have the opportunity to "significantly outperform the index under modest growth performance scenarios" but "will underperform standard participation products in the event of strong market growth" because of the cap, Future Value Consultants wrote in a report.

The fact that the underlying is the S&P MidCap 400 index, however, could mean that investors are getting a higher return cap than they would if the underlying were the more common S&P 500 index, Hampson said. That is because the smaller S&P MidCap 400 index is more volatile than the broader S&P 500.

"The S&P 500 [historical volatility] is about 21%, and the S&P MidCap 400 is about 24%, so there's a bit more volatility," Hampson said. "So with this sort of stuff you'd expect to see a slightly higher cap compared to something with the same downside and gearing linked to the S&P 500."

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