JPMorgan, HSBC notes linked to Euro Stoxx eyed by advisers in aftermath of Italy’s ‘no’ vote

By Emma Trincal

New York, Dec. 5 – Two upcoming leveraged note offerings referencing the euro zone equity market caught advisors’ attention on Monday in the wake of the “no” vote in Italy, which precipitated the resignation of Prime Minister Matteo Renzi.

The market reaction to the event was bullish despite analysts’ predictions of political instability down the road.

“The market dropped and immediately bounced back. It’s a knee-jerk reaction,” said Win Thin, senior analyst at Brown Brothers Harriman. “The euro was down to 1.05 and went back up to 1.07 shortly after. Just like the U.S. elections or Brexit, people review the impact after the initial panic. It was different with the Italian referendum though because the ‘no’ was not a surprise. It was expected.”

Two deals

The two deals are both linked to the Euro Stoxx 50 index. Both feature leverage on the upside. They differ in length and in their respective type of downside protection.

The first deal is short in term, capped and buffered.

JPMorgan Chase Financial Co. LLC’s 0% return enhanced notes due Dec. 26, 2018 give investors two times the index gain at maturity up to a 36% to 40% cap with a 10% downside buffer, according to a 424B2 filing with the Securities and Exchange Commission.

The second offering is a five-year barrier leveraged note with no cap.

HSBC USA Inc.’s 0% leveraged Buffered Uncapped Market Participation Securities due Dec. 31, 2021 provide a 1.45 times leverage factor on the upside and a 75% barrier on the downside observed at maturity, according to an FWP filing with the SEC.

Five-year offering

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he is very impressed with the JPMorgan offering.

“Both deals are good, but the two-year is exceptionally good,” he said.

“Normally I would be looking at the five-year because we like long-term investments. We also tend to extend the duration to get better terms. But the short-term one is just fantastic.”

Kalscheur followed a statistical methodology he uses to evaluate deals. He looked at this index’s past returns based on a yearly performance table his firm compiled for most benchmarks in order to evaluate loss and gain probabilities over a particular trailing period. The data captures the past 30 years.

The methodology revealed a 16% probability for the Euro Stoxx 50 to drop more than 25% over a five-year trailing period.

“You have one chance out of six of breaching the barrier. It’s a bit too much for me to feel confident about that,” he said.

Upside

The same note, however, has an attractive potential return.

“The upside is fantastic,” he said.

But while the leverage and uncapped exposure allow investors to score significant gains, the benchmark’s track record is less striking.

The median return on the Euro Stoxx 50 over a five-year period is 25%, he noted. The statistic simply means that there is an equal chance for the index return to fall above or below 25% over a five-year trailing period.

“I don’t know why it’s so low. This index has not done very well,” he said.

For instance, at maturity, if the index finishes up 25%, the leverage in the notes would boost the return to 36%. But this would only represent a return of 7% a year.

“The median is definitely lower than I anticipated,” he said.

The mean, however, is higher, he added.

“This index has been all over the place. It can go up a lot. With no cap, you could knock the ball out of the park with this. If you’re a raging bull, that’s definitely the product to go with. But can it go down by more than 25%? You bet,” he said.

“It’s not a bad offering, but we buy those notes for the downside protection. I’d rather have a little less leverage on the upside and a better barrier, something like 40% on the downside.”

Two-year deal

Kalscheur expressed a strong preference for the JPMorgan offering. With its 36% to 40% cap and two-times leverage, the two-year JPMorgan product can deliver between 16.6% and 18.3% per year on a compounded basis, which is “pretty darn good,” he said.

The 10% buffer is “very good,” he noted, adding that he prefers buffers to barriers. While HSBC’s barrier gives more protection (25% versus 10%), it is contingent, not guaranteed, protection.

JPMorgan’s notes are also very compelling on the upside despite the cap. The odds of seeing the Euro Stoxx 50 climb over the 40% maximum cap after two years is only 23% on any two-year trailing period, he said.

Separately, the probability of a decline in the index of more than 10% is 24.5%.

Cap, dividends

“I’m going to be better off with this note most of the time. I’m going to outperform on the downside even if the index falls by more than 10%. The cap on the upside is really high,” he said.

The high cap level on such a short-term period is one of the most “intriguing” aspects of the deal, he said.

“The caps are notoriously disappointing on many of those products. I’m used to seeing two-year [issues] on the S&P with an 18% to 22% cap. That’s nothing to crow about.”

Part of the reason the issuer may have been able to price the notes so attractively, he said, is because the underlying index offers a very generous dividend yield of 3.58%. Over the term, investors will not collect the 7.15% dividend return.

Still, in terms of protection, investors in the notes are “ahead” of the index by three percentage points.

The second attractive part of the JPMorgan deal is the low cost structure of the notes, he said pointing to the 60 basis points fee.

The fee is “just crazy inexpensive. It’s very rare even in the institutional space,” he said.

“This is an exceptional offering. We are going to take a serious look at it. It’s really exciting, especially if you have a client who is a little bit disgruntled about international performance, “he said.

Kicking the can

Carl Kunhardt, wealth adviser with Quest Capital Management, said he prefers the two-year product too but for a different reason.

“Both deals are very attractive,” he said.

The fee on the HSBC note is 3.6%, which on an annualized basis remains competitive.

His rationale is the duration.

“If I had to pick one, I’d pick the JPMorgan two-year because Europe has systemic issues they’re going to have to address,” Kunhardt said.

The European Union “is a mess” and has so far avoided to deal with its “problems,” he said, which leads him to think it is unlikely to make any changes in the short run.

“They have yet to solve the fiscal issue. You cannot have a disconnect between the fiscal policy and the monetary policy. There is no unified fiscal policy in Europe, and it’s not sustainable,” he said.

He offered a historical comparison.

“The first years of the U.S. were very similar to what Europe is today. Prior to our Constitution, the U.S. had a very weak central government,” he said.

“Europe is in a very difficult crossroad. Outside of the U.K., Germany and France, the other countries are second-tier economies.

“I prefer the short term based on my outlook. There will be systemic issues in Europe, but I don’t think we’ll see that in the next two years. More of the cracks are going to be evidenced within that five-year period.

“The terms of the two notes are different enough that it’s not an apple-to-apple comparison. I like them both. But because of my concerns about Europe as an entity, I’d rather be on the short term of this trade.”

J.P. Morgan Securities LLC is the agent for JPMorgan Chase Financial’s notes. JPMorgan Chase & Co. will be the guarantor. The notes (46646QCL7) will price Dec. 20.

HSBC Securities (USA) Inc. is the underwriter for HSBC USA’s notes. The notes will price Dec. 21. The Cusip number is 40433UB70.

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