JPMorgan’s leveraged buffered notes linked to index basket seen as a proxy for EAFE exposure

By Emma Trincal

New York, Oct. 26 – JPMorgan Chase Financial Co. LLC’s 0% capped buffered enhanced participation notes due Nov. 1, 2018 linked to a basket of indexes are the latest in a series of numerous trades designed to give investors an alternative to the MSCI EAFE index, a market participant said.

The basket consists of the Euro Stoxx 50 index with a 37% weight, the FTSE 100 index with a 23% weight, the Topix index with a 23% weight, the Swiss Market index with a 9% weight and the S&P/ASX 200 index with an 8% weight, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus triple any basket gain, up to a cap of 20.76%.

Investors will receive par if the basket falls by up to 10% and will lose 1.1111% for each 1% decline beyond 10%.

A classic

“I’ve seen this basket many times, exactly the same thing,” the market participant said.

Data compiled by Prospect News shows that this particular basket – with the same country mix and weightings – became commonly used in the second half of 2014. So far this year, it has been employed in 84 deals totaling $553 million. Several agents have participated in these offerings with a variety of issuers, including JP Morgan, GS Finance Corp., Morgan Stanley, Barclays Bank plc, Credit Suisse AG, London Branch, Royal Bank of Canada and Toronto-Dominion Bank.

EAFE alternative

“If I remember it correctly, it’s designed as an alternative to EFA. That’s my guess,” the market participant said.

The acronym “EFA” is often used to designate the iShares MSCI EAFE exchange-traded fund, as it is the fund’s ticker symbol on the NYSE Arca. The fund tracks the MSCI EAFE index, an international equity benchmark for developed markets excluding the United States and Canada.

“A note with that basket as the underlying will probably price better than a similar note using the ETF. These are more liquid country components. The EFA contains markets that may not be as liquid,” the market participant said.

“This basket is more concentrated. It probably represents a major part of the index.”

A comparison between the iShares MSCI EAFE’s components and the basket’s constituents revealed similitudes between the two assets, at least for the major constituents.

The top country holding in the EAFE fund is Japan at 24.3%, according to the iShares website, which is close to the 23% allocation to this country in the underlying basket.

The basket’s highest weighting is the Euro Stoxx 50, representing the euro zone stock market. When adding euro zone countries included in the EAFE fund, one finds a total allocation of 35% to the Euro Stoxx 50, in the same ballpark as the 37% weighting in the basket.

The FTSE 100 represents 23% of the basket. The United Kingdom is the second country allocation in the ETF with 17.74% of the portfolio.

Allocations to the Swiss equity market are very similar with 8% in the basket and 8.65% in the ETF.

The only main difference is the 8% allocation to the S&P/ASX 200 index while there is no exposure to Canadian stocks in the ETF given that by definition, the EAFE index excludes North America.

Quanto

The market participant suggested that investors may have other reasons to opt for the notes instead of the ETF.

“There may be some advantages like quanto, which means that exchange rates do not affect the performance of the notes,” he said.

Indeed, the prospectus said that the notes do not provide direct exposure to fluctuations in foreign exchange rates. This feature is called quanto. The term refers to an options used to eliminate currency risk by hedging it, which is an advantage offered by the notes and not available to equity investors.

As a result, investors in the notes will not gain or lose from any depreciation or appreciation of the dollar relative to the currencies for the component markets, according to the prospectus.

Pricing

“The structure makes sense if you’re seeking exposure to the EFA,” the market participant said.

“It’s a mildly bullish play. You get three times leverage.

“If I’m moderately bullish on this market and if I use this basket as an approximation of EFA, it’s a good way to outperform the index. You get better terms on the structure.

“My guess is that if you did this note using the ETF, you may get a 15% to 17% cap, not 21%.”

Terms

A financial adviser said he likes the structure.

“We see a lot of income products with low coupons. I like this a whole lot more. At least you get diversification,” this adviser said.

“It’s unlikely that all those international indexes will be down at the same time.

“It’s a very reasonable cap. I like it.”

The cap on an annualized compounded basis is 9.9%.

Usually, this adviser avoids geared buffers. But given the diversification of the underlying portfolio, he said he would not be opposed to it in this case.

“The gearing on the buffer is not going to overcome the benefit of this buffer. It’s a good size buffer on a two-year. The 10% makes that gearing become a non-issue,” he said.

The leverage on the upside is not his favorite feature.

“I don’t think much of the 3x leverage. All it’s going to do is get you to the cap quicker.”

A 3.4% index increase a year would be enough to bring investors to the cap, he noted.

“It’s unlikely that you’re going to get three times without hitting the cap on this one.

“Perhaps I would have gone for a two-times leverage with a higher cap. That may have been a little bit better.”

J.P. Morgan Securities LLC is the agent.

The notes will be guaranteed by JPMorgan Chase & Co.

The notes were scheduled price on Thursday and settle on Nov. 3.

The Cusip number is 46646E2F8.

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