JPMorgan’s review notes linked to Euro Stoxx Banks, financial fund offer range-bound play

By Emma Trincal

New York, Aug. 14 – JPMorgan Chase Financial Co. LLC plans to price 0% review notes due Aug. 23, 2021 linked to the lesser performing of the Euro Stoxx Banks index and the Financial Select Sector SPDR Fund, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus an annual call premium of 14% if each underlier closes at or above its initial level on any annual call date.

The payout at maturity will be par plus 10% unless either underlier finishes below its 70% trigger level, in which case investors will be fully exposed to the losses of the lesser-performing underlier.

The structure appears attractive for an investor ready to see the notes called after just one year, said Carl Kunhardt, wealth adviser at Quest Capital Management, who said that statistically this is the most likely scenario.

From a rational point of view, the notes seem like a “good idea,” but Kunhardt said he is not comfortable with the deal.

European banks

“I don’t have a lot of issues with it, but for some reason I don’t like it. I get this gut feeling. ... Somehow it doesn’t feel like it’s a good investment, but I couldn’t say why,” he said.

Objectively, he was able to counter most of the objections one may have when considering the product.

For instance, many investors do not like having their return linked to the worst-performing asset. Kunhardt said that he does not like worst-of payouts himself. But with this note, the two underliers have a 0.98 correlation.

“When you get such a high correlation, do you really have two indexes? I don’t think so,” he said.

High correlation between two underliers lessens the risk of a worst-of product because the chances of losing money are greater when the underliers move in opposite directions.

Some advisers criticize worst-of payouts because not knowing in advance what the worst performer will be makes it difficult to manage risk.

Kunhardt had an answer to this objection as well.

“I think we pretty much know what the worst of is. Europe has yet to fix its issues with Southern European countries. The banks there have made stupid loans. You can almost write off the SPDR. If there is going to be a worst of, it’s going to be the shares of these European banks,” he said.

Call, dividend

The four-year tenor involves taking on JPMorgan’s credit risk. For some, long durations are not an option. But Kunhardt countered the concern again.

“Not only is this not an issue, it’s moot because I don’t think you’re going to be invested for four years.

“You’re getting called in one year. Four years is on paper.”

The 14% annual return, even after dividends, is a “very decent” cap, he noted.

The Euro Stoxx Banks index pays 6.4% in dividends. The dividend for the Financial Select Sector SPDR ETF is 1.5%.

Since investors only lose the dividends paid by one of the two underliers, he assumed that the opportunity cost would be an average dividend rate of 4%. Therefore investors would net 10% a year.

“Are you willing to live with this for a year with a net return of 10%? It’s hard to say no,” he said.

“The numbers are what the numbers are. I wouldn’t do it in a conservative portfolio, but I may for a more aggressive client.”

Looking at most risks – credit risk, call risk, correlation risk – Kunhardt could not find “what could go wrong.”

“And this is what scares me in a way. After doing this for 20 years, I know there is no such thing as no risk. Not even Treasuries.”

Downside

The principal is at risk at maturity when the notes have failed to be called. By virtue of the structure, such scenario means that at least one of the underliers is negative.

“This is the risk in theory, but I don’t see that happening at all,” he said.

“There is little to no chance of getting past the first year without a call.

“You’re going to get this 14% in the first year. That’s the most probable scenario.”

But even if the notes finish negative, Kunhardt does not envision any loss of principal. In fact, investors will get 10% for the four years, which is a small gain but better than only getting one’s principal back, he noted.

“What are the odds that in the next four years those top European banks are going to see their stock drop 30%? I don’t see the European governments allowing any of those banks to fail,” he said.

“The numbers and the logic say just do it. But something tells me don’t. I just don’t see what could go wrong. I guess that’s the problem. If you don’t see the risk, that’s when you’re in trouble.”

Strong years

For Dick Bove, financial stock analyst at Rafferty Capital Markets, the notes would only be a good fit for investors with a range-bound view on the sector. Neither bull nor bear investors could benefit from it.

For a bull, getting 14% per year may not be enough.

A lot of the bullishness has been fueled by “hopes” of higher interest rates. Bove said the market is not seeing what really drives the earnings and stock prices of U.S. banks.

“Everybody is focusing on interest rates, buybacks and regulation cuts, but what’s important is what a company is going to sell,” he said.

“Banks have done extremely well for seven years, between 2010 and 2016. During that time, interest rates were the lowest they’ve ever been and banks’ earnings reached all-time highs. Why? Because banks were making loans, that’s one. And two, they stopped making bad loans.”

Fewer loans

But the growth of those good years is now on pause, and a rise in interest rates is unlikely to make a difference, he said.

“Banks are no longer doing well selling their loans. Since the second half of last year, loan volume has either slowed down or dropped; in some cases it’s falling off the cliff like in commercial real estate. The economy is showing no strength. You can’t go on forever without bad loans, and bad loans are creeping up.”

A reverse trend – fewer loans and more bad loans – is now developing, one that is likely to keep bank stock prices from rising, he predicted.

“If you think the sector will get you a 5%, 6% or 7% annual return, then it works. You get 14% with the notes.

“But if there is a recession coming up, both [underliers] are going to be in negative territory.

“In that case, you walk away with 10%, which is nothing. Or you get hit with a loss of at least 30%, which I don’t think is likely. Either way, if it’s down, it’s not what you expected.”

Instead, Bove said that a bullish investor would be better off investing in the sector funds directly.

Bears would not use the notes, which are not designed for them.

Only someone predicting that bank stocks will trade sideways would find it interesting.

“But if banks no longer make loans and if we’re in a recession, bank stocks are not going to trade sideways. They’ll be more volatile.

“I wouldn’t want to take that risk.”

J.P. Morgan Securities LLC is the agent.

The notes are guaranteed by JPMorgan Chase & Co.

The notes will price on Friday and settle on Aug. 25.

The Cusip number is 46647MM75.

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