High dividends ease pricing, leverage for JPMorgan’s buffered leveraged notes tied to Stoxx

By Emma Trincal

New York, March 22 – JPMorgan Chase Financial Co. LLC’s 0% capped buffered return enhanced notes due April 5, 2024 tied to the Euro Stoxx 50 index offer attractive pricing thanks in part to a high-dividend paying underlying index, said Suzi Hampson, head of research at Future Value Consultants.

If the final index level is greater than the initial index level, the payout at maturity will be par plus 4 times the index return, subject to a maximum return of at least 120%, according to a 424B2 filing with the Securities and Exchange Commission. Investors will receive par if the index declines by 20% or less and will lose 1% for every 1% that it declines beyond 20%.

High cap

“The index has a volatility of 16.7%. With 4x leverage, achieving the maximum return doesn’t sound widely unlikely,” she said.

The Euro Stoxx only needs to be up 5.4% a year and investors may hit the cap, she said. This represents a 17% annual rate of return on a compounded basis.

“The terms are attractive,” she said.

In order to price the structure, the issuer used a high-yielding index. For noteholders, the tradeoff is to give up the 3.15% yield offered by the Euro Stoxx 50 for five years.

Future Value Consultants produces stress testing for structured products. The objective is to assess probabilities of outcomes, which are a reflection of the way the notes are priced and the type of structure employed.

Neutral basis

Hampson explained the basics of her firm’s simulation model.

“Pricing is based on the neutral assumption, which reflects the common factors used for the pricing of structured notes,” she said.

“You have to take away all investing knowledge and assume that the underlying will grow at the risk-free rate minus all the dividends that it will pay out.”

The neutral scenario produced by Future Value Consultants makes assumptions about the growth of the underlying that are unrealistic for an investor, she explained. Pricing out of the risk-free rate by definition eliminates the risk inherent to equities.

Negative forward

The notes benefit from what is known as a cheap forward rate.

In simplified terms, the forward rate is obtained by subtracting dividends from the risk-free rate, she explained.

Since the local rates in the euro zone are close to zero and the dividend yield of the underlying is high, the forward will be negative.

“When you use a high-yielding index like the Euro Stoxx, it will push the forward rate down. It’s an advantage in terms of pricing.

“Negative forwards cheapen the cost of the call options because you’re less likely to see the price going above the strike. This is one of the reasons they were able to price the notes with such a high gearing.”

Buyers of a call option make money when the underlying price moves above a selected strike price. In this case the strike is the initial price of the index.

“Also, the cap is really high. It doesn’t look like being capped at 17% a year would be a concern for investors. It’s definitely worth something.

Another benefit offered by the structure was the 20% buffer, she noted.

Four other markets

Future Value Consultants offers four market scenarios, which are more representative of the market than the neutral scenario designed for pricing. Those are: bull, bear, less volatile and more volatile.

“If you’re going to invest in equities, you can’t assume the underlying will grow at a neutral pace. It would not reflect an accurate market view.

“This is why we give our clients other options than the neutral scenario so they can run tests based on their own view.”

However even those four market scenarios reflect very conservative assumptions, she added.

“We are not predicting any growth. We don’t know how much the index will increase or fall. But we do know the dividend. It’s the behavior of the neutral scenario that defines pricing. Our bull and bear assumptions are close to the neutral scenario because we want to be consistent with the model. We also want to stay away from predicting the market.”

That said, the bull scenario will always present better outcomes than the neutral one as illustrated in Future Value Consultants’ report on this product.

Score card

The firm’s specialty is to provide stress testing for the structured notes that it rates. Those are probabilities of outcomes. They are calculated based on the assumed rate of growth of the underlying for each market environment as well as other important metrics, such as implied volatility.

Hampson first looked at the “investor scorecard” contained in the report. This test or “table” showcases the probabilities of outcomes under the neutral scenario only. Those are “positive return,” “full capital return” and “capital loss.”

The probabilities of losses are surprisingly high at 44.1%. On the other hand, investors have a 33.7% chance of getting a positive return. Within this 33.7% bucket, the chances of “capping out” are 11.5% probability. Finally, 22.2% of the time, investors will only get their principal back with no gains.

“As you can see, the neutral scenario doesn’t mean much. You wouldn’t invest in equities if you expected such a low growth. Nobody would make any investment based on such probabilities,” she said.

“The neutral scenario is only the basis of our simulation. It is not designed to make investment decisions.

“The neutral is how the terms are achieved. It’s just what’s coming off the pricing model.”

Bull to the rescue

She then switched her attention to another table in the report named “capital performance tests, which unlike the scorecard add to the neutral scenario the four other market types.

Under the bull scenario, this test showed a 62.5% chance of getting a positive return. Within this bucket the probabilities of hitting the maximum return were as high as 35.4%. The chances of losing money fell considerably under the bull, down to 19.9% compared to 44.1% in the neutral.

“This product has the potential to pay very high returns. But given the relatively moderate volatility, the muted expected growth in the underlying and the high dividends, the chances of being below the initial price are also quite high,” she said.

To be sure, the table under the best scenario (bull) reveals a 17.6% chance of getting only 100% of the initial investment. Losses will happen 19.9% of the time.

Adding those two last probabilities showed 37.5% probabilities of neutral or negative outcomes.

A different exposure

Ultimately investors base their decisions on a market outlook, which is theirs, and not just on probabilities, she said.

“We’re not financial advisers. But some investors who have or want to have exposure to the Euro Stoxx could be happy to take the risk,” she said.

“These are good terms.” She pointed to the 20% buffer and to the 35% probabilities of getting a “very high return” of 17% a year.

“If you like the euro zone, perhaps this gives you more chances of a positive outcome than an ETF.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price April 1.

The Cusip number is 48130WL66.

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