JPMorgan, other issuers link 'worst-of' structures to stock baskets in effort to boost yield

By Emma Trincal

New York, May 21 - As investors continue to search for yield, firms are rethinking their approach to some standard structures, adjusting them for higher returns. One recent way has been the use of stocks as the underlying of "worst-of" structures as opposed to the more common use of equity indexes, sources noted based on recent filings.

"These are structures created for yield. There is more risk in individual stocks than doing index-based structures," said Dean Zayed, chief executive of Brookstone Capital Management.

Some of those recent deals pay a call premium when the autocallable feature is triggered; others pay a fixed coupon as a standard reverse convertible. A barrier - usually final and not observable through life - will determine the amount of potential loss of principal, if any. The payout will be linked to the worst-performing stock if even just one stock breaches the barrier. On the other hand, the autocall requires all stocks to be above a certain threshold in order to be triggered on a specific date, usually quarterly.

Those conditions and the risk linked to the low correlation between the underlying stocks usually make for higher coupons and lower barriers than the traditional reverse convertible, sources said. But the structures involve also more risk and more complexity, they added.

The most common types of recent worst-of deals seen over the past few weeks fit into the autocallable category, according to data compiled by Prospect News.

The notes will be automatically called if the price of all the underlying stocks are above their respective initial prices on any call date.

Zero-coupon autocallable

JPMorgan Chase & Co. for instance announced last week the pricing of autocallable contingent interest notes due May 26, 2015 linked to the least performing of the common stocks of Caterpillar Inc., Citigroup Inc. and Occidental Petroleum Corp., according to an FWP filing with the Securities and Exchange Commission.

If each stock closes at or above the 70% trigger price on a quarterly review date, the notes will pay a coupon at an annualized rate of 13.4% for that quarter.

If each stock closes at or above its respective initial share price on any review date other than the final review date, the notes will be called at par plus the coupon.

If the notes are not called and each stock finishes at or above its trigger price, the payout at maturity will be par plus the coupon. Otherwise, investors will receive a number of shares of the least-performing stock equal to $1,000 divided by that stock's initial price or, at the issuer's election, the cash value of those shares.

"For those sophisticated investors seeking yield who understand the nuances of structure and who are aware that securities tied to individual stocks are more risky in nature, it may not be a bad idea," Zayed said.

"I'm actually a fan of these types of products but at one condition: the client has to understand the terms."

JPMorgan priced two small autocallable deals that were rather similar.

The first one was $1 million of autocallable contingent interest notes due June 4, 2014 linked to the lesser performing of the common stock of Baker Hughes Inc. and the registered shares of Weatherford International Ltd.

The interest barrier is 65% of the initial price with quarterly review. If each stock closes above it, the notes will pay a contingent coupon of 2.9%, equivalent to 11.6% per year. Otherwise, no coupon will be paid that quarter.

If each stock closes at or above its initial price on any quarterly review date other than the final review date, the notes will be automatically called. At maturity, investors will receive par unless at least one stock closes below the trigger, in which case investors are fully exposed to the decline of the lesser performing stock.

The second deal also sold for $1 million and has the same maturity. The notes are linked to the lesser performing of Masco Corp. shares and Weyerhaeuser Co. shares. The barrier is final and set at 65%. The call premium is the equivalent of 12.6% a year. Review dates for the contingent interest and autocall are quarterly.

"Obviously the risk is also a function of the stocks that issuers are choosing, a choice that will dictate the terms," Zayed said.

"I find the first deal tied to Caterpillar, Citigroup and Occidental rather interesting because these are pretty large cap stocks. I would've thought that one of the three would be more speculative to help with the juice. So yes, there is risk involved with the low correlation between those names. But at the same time, you're talking about pretty stable stocks.

"I like the idea of structuring those worst-of [notes] on stocks. I think it's a creative way to get yield as long as you understand it.

"Volatility as a whole is very low and people need yield, so I would not be surprised to see more of these."

Coupon-bearing worst-of note

Several recent single-stock-linked worst-of notes followed a slight different model as they pay a fixed interest rate. The majority of those products featured a final barrier with quarterly observation dates for the autocall.

HSBC USA Inc. for instance priced late last month $3 million of 7.8% autocallable notes due July 31, 2014 linked to the common stock of Boeing Co. and Halliburton Co., with JPMorgan as the agent.

The notes re called automatically if both stocks close above their respective initial prices on any quarterly observation date. The final barrier is 65%.

Around the same time, Royal Bank of Canada priced $3 million of 9.6% autocallable reverse convertible notes due Nov. 6, 2014 linked to the common stocks of Deere & Co. and Cummins Inc. The same terms applied.

Separately, JPMorgan sold last week $4 million of two-year autocallable securities issued by Deutsche Bank AG, London Branch. The notes are tied to the least performing of the common stocks of Exxon Mobil Corp., Dow Chemical Co. and Amazon.com, Inc. Investors receive an annualized coupon of 9.75%.

The trigger price is 65% of the initial value.

If each stock closes at or above its respective initial share price on any review date, the notes will be called at par plus the coupon.

"Before showing this to an investor, you would really have to do some serious due diligence. One of the main things is to make sure that the client has held individual stocks before. A lot of investors have never owned stocks but just funds," Zayed said.

"This is the type of product that requires a relatively sophisticated investor and an extra level of education. Clearly those notes are not principal protected. The structures give you some very sexy return upfront, but in reality, you do have equity stock risk.

"A big part of it is education. Any investor who doesn't understand these products ultimately runs the risk of getting burned."

Whacky risk

Jonathan Tiemann, president of Tiemann Investment Advisors, LLC, pointed to the risks incurred by investors when buying those products.

"Say you have this 70% barrier. If only one of the stocks drops by more than 30%, you're not getting called. You can go from quarter to quarter and earn nothing since you need the two or three stocks to behave the same way," he said.

"If you only had one underlying stock, you'd be short a put option. But here, it's more like you're short a portfolio of put options, which is bad enough, and each stock potentially inflects the others."

He was referring to the added risk involved when the underlying stocks show little to no correlation.

"The lower the correlation between those stocks, the greater the chance of breaching the barrier," he said.

"If one drops by a third, it doesn't matter what the other two do. It's as if you were short a portfolio of put options with a major difference: your stocks in this note are interdependent. If one of the stocks turns out to be a bad bet, it has an impact on the others, which would not be the case with a portfolio of put options. Granted, given the barrier level of 65%, your odds of losses are not that high. But if you're hit with a loss, it's bad."

The idea of taking equity risk to achieve income was not shocking in itself, he said. But he added that he was not comfortable with this type of note to achieve such goal.

"You're certainly taking on equity risk, that's obvious. But it's kind of a whacky form of equity risk. I see it as a particularly odd way of reaching for yield," he said.

"If one of the underlying stocks falls off the table in a short period of time, you can find yourself not only not receiving any income but forced to hold the note for quite some time with a potentially big loss at maturity.

"I can see why someone would do it for the yield. I'm just not sure that's the right way to get yield. Here you have an investor who is hungry for yield and then you have someone proposing to this investor an instrument that's really complex, with a wide range of possible outcomes.

"Nothing is more expensive than reaching for yield in this investment world.

"The triggers are pretty deep-out-of-the-money, and that's not bad. But if you're using three widely divergent underlying stocks, you're adding a significant amount of risk because the less correlated they are, the more likely one of them will go in the wrong direction."

Hansel and Gretel

All the recent worst-of products compiled by Prospect News showed a barrier observed at maturity only. Barriers or "knock-ins" observable during the life of the notes were less common even though they can offer the advantage of lowering the barrier level.

Last week however, Credit Suisse AG, Nassau Branch announced plans for a deal with a barrier monitored daily. The issuer planned to price 10% callable yield notes due Nov. 24, 2014 linked to the common stocks of Facebook, Inc. and LinkedIn Corp. on May 17.

Interest is payable quarterly.

The notes are callable at par plus the contingent coupon on any interest payment date.

The payout at maturity will be par unless either stock ever closed at or below its knock-in price during the life of the notes, or 50% to 53% of the initial level.

A sellsider said that the use of stocks instead of indexes in the structuring of worst-of notes was not a good sign.

"As the volatility drops, the coupons on the worst-of [notes] tied to indexes diminish," he said.

"Greedy investors fall back on more risky investments to keep coupon levels high; that greed is often kindled with investment banks offering these riskier products in the first place.

"Think of Hansel and Gretel lost in the forest with nothing to eat. Investors have no coupon or small coupons. They stumble upon the evil witch's gingerbread house. They know they shouldn't eat any of it, but as they are starved, they try all the same. Out comes the witch and [invites] the children in for more. ... The rest of the story you know. ... For me this looks like a deja vu of 2008."

The Cusip number for the JPMorgan notes linked to Caterpillar, Citigroup and Occidental Petroleum is 48126NAN7.

The two other JPMorgan deals have the following Cusip numbers: 48126NAD9 for the notes linked to Baker Hughes and Weatherford and 48126NAC1 for the notes linked tied to Masco and Weyerhaeuser.

The Cusip number for the notes issued by HSBC is 40432XF30.

The RBC-issued notes have the following Cusip number: 78008ST55.

The Cusip numbers for the notes issued by Deutsche Bank and Credit Suisse are 25152RCZ4 and 22547Q2E5, respectively.

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