JPMorgan's notes tied to indexes use structuring twist to enhance return, raise cap

By Emma Trincal

New York, Dec. 20 - JPMorgan Chase & Co.'s 0% capped notes due Jan. 10, 2014 linked to a weighted basket of three buffered return enhanced components give investors some global equity exposure with potentially enhanced terms due to a structuring method based on individual caps and buffers at each index component level, sources said.

The basket consists of the Euro Stoxx 50 index with a 56% weight, the FTSE 100 index with a 23% weight and the Topix index with a 21% weight, according to a 424B2 filing with the Securities and Exchange Commission. The indexes' underlying currencies are the euro, the Japanese yen and the British pound sterling, respectively.

The payout at maturity will be par plus the basket return, which will equal the sum of the weighted component returns of the basket indexes.

If an index's final level is greater than its initial level, its component return will be double its return, subject to a maximum return of 15.3% for each index. If the index declines by 10% or less, its component return will be zero. If the index declines by more than 10%, its component return will be 1.1111 times the sum of its return plus 10%.

Steve Doucette, financial adviser at Proctor Financial, said that applying the buffer and the cap to the three basket components separately was part of an effort from the issuer to come up with better terms.

Correlation risk

"There are a lot of moving parts in these notes," he said.

"It seems to be the trend. Issuers are looking at multiple indices, either as 'worst of,' 'best of' or in a basket because blending these equity benchmarks can give you better pricing when volatility is so low," he said.

His main concern however was whether the indexes had been chosen to simply do that - boost volatility and raise the cap - or if the selection made sense from an investment standpoint and was based on a research-based theme.

Investors, he said, should not just look at the basket. They should analyze the correlation between the individual indexes.

"Although this is a basket and 'not a worst of,' you're still subject to some risk if correlation is low," he said.

"What if the Euro Stoxx performs well and the other two drag the overall return down?

"I don't know how the Euro Stoxx stacks up against the other two. But you do have to look at correlations and weightings."

Do your homework

Because the Euro Stoxx index makes up 56% of the basket, the performance of the notes will depend significantly on the euro zone equity market, the prospectus said in its risk section.

"The weightings suggest that the notes are for people who expect the European stock market to bounce back," he said.

"I don't have a view on any of these indexes and I'm not in the habit of making projections.

"But you certainly have to do your due diligence, look at the correlations and decide whether this note is worth considering."

Doucette said that he would "not spend the time doing the due diligence" on the basket.

"This basket is a very unique pick of three global equity markets. I'm not sure why they selected that particular mix. I suppose they were simply looking for ways to create volatility. You get a bit of leverage. You can increase the cap on the upside.

You do those individual caps so that you can create ways to fund a higher cap. It's creative financial engineering in a low volatility environment. But does this basket make sense for an investor? How do they come up with the mix? You still need to have a view and you need to see how those pieces move together.

"Once you get through the moving parts though, it's a pretty straightforward note," he said.

A good mix

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said that he liked the product both for the underlying market theme and for the structure.

"What's interesting is the diversification within this one note," he said.

"The basket gives you an opportunity to generate gains for the next 13 months. You can get two times leveraged return up to a cap for each index.

Because each component of the basket is denominated in the local currency, investors can benefit from a potential exchange rate gain if at maturity the U.S. dollar has depreciated against the basket currencies, according to the prospectus.

"The currency play is also attractive. A decline of the dollar can provide additional gains," said Medeiros.

"I like the possibility of earning more at maturity if the dollar falls. I see it as a real possibility because I believe that what drives the dollar up is the flight to safety and market volatility. Once the global economy recovers, people may realize that the dollar is relatively overvalued."

Medeiros said that he was comfortable with the equity mix.

"I like Japan. I'm not as familiar with the U.K. market as I am with the euro zone. I believe the Euro Stoxx should do well over 13 months if they do the right thing," he said.

The Euro Stoxx 50 is up 14.75% year to date. After dropping by 20% in April and May, the benchmark recovered and has gained 28.5% in the past seven months.

"European stocks have been beaten up and have bounced back. I see more appreciation potential," he said.

"The basket it designed for those who want to be able to catch up to that rebound."

Reading alpha

Medeiros said he was comfortable with the short duration as well as the terms.

"I would like to see a bit of a higher cap, but over a 13-months period 15.3% is reasonable. The 10% buffer is definitely fine," he said.

The calculation of the cap and buffer at the index level was seen as an advantage.

"I like the capping and buffering for each index as opposed to doing it at the basket level," he said.

"For me, transparency is appealing. It's a plus to be able to track individual components even though I can't do anything about the terms. I like the idea of understanding my alpha distribution and where I'm getting my return."

J.P. Morgan Securities LLC is the agent.

The notes will price on Friday and settle on Dec. 27.

The Cusip number is 48126DPZ6.

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