JPMorgan's $30 million fixed-to-floating leveraged CMS, S&P 500-tied notes seen as noteworthy

By Emma Trincal

New York, Sept. 4 - JPMorgan Chase & Co.'s $30 million of fixed-to-floating-rate leveraged CMS curve and S&P 500 index-linked notes due Aug. 31, 2028 caught the market's attention when the deal priced last week due to the terms and the sophisticated hedging required to price the notes, according to market sources.

The interest rate is 10% for the first year. After that, it will be five times the spread of the 30-year Constant Maturity Swap rate over the five-year CMS rate, subject to a maximum rate of 10% per year, multiplied by the proportion of days on which the index's closing level is at least 55% of the initial level, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable quarterly and cannot be less than zero.

The payout at maturity will be par.

"You have a combination of a new name. JPMorgan is kind of rare as an issuer in the rates space. Morgan Stanley probably provided the underlying derivative on that," a market participant said.

"It was good because the five times multiplier is higher than what we've seen and the 55 barrier is low on the range.

"The fact that rates have sold off must have helped too."

J.P. Morgan Securities LLC was the agent, and Morgan Stanley Smith Barney LLC distributed the notes, according to the prospectus.

Sophisticated derivatives house

"Morgan Stanley at this point seems to be the only house that can price a steepener combined with equity risk. It's a multifactor model including equity and rates, and the hedging is very complex. I'm not saying other firms are not working on similar deals, but at this point, Morgan Stanley seems to be ahead of the game on these structures," the market participant added.

"With this deal, in particular, Morgan Stanley is the only one that can do the underlying swaps.

"The name of JPMorgan combined with the structuring of Morgan Stanley is definitely an example of the positive aspect of an issuer and a structurer combined to create a good product."

Agents have priced 17 deals totaling $245 million in hybrid notes linked to both CMS spreads and an equity index, according to data compiled by Prospect News for this year as of Tuesday.

In those structures, the coupon is not only a function of the CMS spread. It also varies based on an equity index level.

Equity benchmarks used in these products have either been the S&P 500 or the Russell 2000, and spreads included all maturities from the two-year to the 30-year CMS rates, according to the data.

As an agent, Morgan Stanley priced 13 of those deals totaling $173.5 million, or about 71% of the total, according to the data. JPMorgan put together bigger but fewer transactions with three deals, including this one, totaling $70 million, or 28% of the total of those structures, according to the data. The other agent was Bank of Nova Scotia in a $1.5 million deal.

"The structure is not new. It's a fixed interest for the first year, then you run the risk of having no coupon. It's a very familiar play combining equity contingency with interest rates movement," an industry source said.

This source agreed that only a limited number of agents could put these deals together. However, he said that JPMorgan was likely to "have done the structuring," with Morgan Stanley involved in the distribution only.

Long-term hedges

"Not all the banks can do it. Some banks cannot do it," the industry source said.

Whoever structured the notes had to be able to use a "very sophisticated technology," he said.

"There's a thing that always amuses me ... it's that with a 15-year deal referencing a 30-year CMS rate, what they really have to hedge is a 45-year rate. Sometimes, I scratch my head," he said.

"If I have to hedge a 10-year rate from today, that's easy. Now if I have to hedge it a year from now, I must hedge over 11 years. Same thing with this product: If I have a transaction referencing a 30-year rate but 15 years from now, I have to hedge a 45-year rate.

"Nothing wrong with it. It's still an interesting play for the investor. Obviously there are risks also involved.

"These notes were probably designed for retail investors who want to express their view on interest rates. It offers an attractive bet on a more positive yield curve if the equity doesn't fall below a certain level. There is a sure thing for the first year with 10%, which is very appealing. Of course, investors are not guaranteed to earn the same coupon or even any coupon the following years.

"These hybrid structures combining steepeners with equity contingency will become more and more popular. It's a more sophisticated trade for investors as well as for the structurers who need to hedge it. But I'm sure those trades will gain more visibility looking forward."

The notes (Cusip: 48126D6M6) priced on Aug. 27.

The fee was 3.5%.

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