JPMorgan’s leveraged notes on FTSE 100 raise concerns due to European headlines, banks

By Emma Trincal

New York, June 4 – JPMorgan Chase Financial Co. LLC’s 0% uncapped buffered return enhanced notes due Dec. 31, 2021 linked to the FTSE 100 index showed compelling terms, advisers said. But they remained cautious as the U.K. is not fully insulated from renewed signs of trouble in the European markets as a result of political chaos in some southern countries and red flags in the banking sector.

If the index closes at or above its initial value, the payout at maturity will be par plus at least 2.1 times any index gain, according to a 424B2 filing with the Securities and Exchange Commission. The exact participation rate will be set at pricing.

If the index declines by up to 20%, the payout will be par. Investors will lose 1% for each 1% decline beyond 20%.

Term

“I like the structure. I like the terms. I just don’t have a strong view on the U.K.,” said Jerrod Dawson, director of investment research at Quest Capital Management.

“We don’t typically make specialized bets on countries. But if you want to invest in the U.K., it’s a very good way to do it.

“You give up the income. But you have the leverage. If you’re right, you win no matter what since there is no cap. If you’re wrong, you get a great downside protection with a 20% buffer.

“If you have a view on this particular market, the structure looks really good.”

Indirect exposure

The problem was the regional exposure to Europe.

“The U.K. is unique. It gives you access to European equity markets. But you’re not exposed to the euro zone directly,” he said.

The U.K. is still a member of the European Union despite the Brexit referendum in 2016. But the country is not part of the euro zone.

“Getting exposure to the British stock market is like playing this European recovery story. Investors have turned somewhat bullish on Europe because the central bank over there is still easing. Stocks valuations are more attractive too,” he said.

Investors in the notes may seek to get some indirect exposure to the European market without being too directly impacted by political and financial troubles in the euro zone.

“That may be the rationale behind this bet. But I don’t know if you’re really insulated from the risk of another financial crisis in the euro zone. I would think the U.K. and the euro zone are quite correlated,” he said.

“We know that a banking crisis can easily spread across all sectors of an economy and across other countries.”

Flashback

He pointed to recent political crises in Italy and Spain, which have revived memories of the European sovereign debt crisis of 2010-12. European bank stocks dropped over the past month. The Euro Stoxx Banks index is down 15% since mid-May and has lost 13% for the year.

The widening of the credit default swap rates of Deutsche Bank has been a red flag for investors of late. From 114 basis points at the end of April, the cost of insuring the debt of the large German Bank has increased to 151 bps, according Markit. Italian CDS spreads are even wider. Unicredit, which was rumored to plan a merger with Societe Generale, according to news reports, shows CDS rates of 118 bps. In comparison Societe Generale has CDS spread rates of 60 bps.

“These are systemic risks. If anything was to happen to one of those large banks, you may be better off if your exposure is limited to the U.K. but I’m not sure to which extent. You would still be heavily impacted,” he said.

Ideal structure

Michael Kalscheur, financial adviser at Castle Wealth Advisors, also expressed a mixed view on the notes, finding more appeal in the structure than in the underlying investment theme.

“The terms of this deal are pretty much everything we usually want, “said Kalscheur.

“It’s a good length of time. The creditworthiness of the issuer is great. There’s a lot of leverage on the upside and it’s uncapped. In addition to that, you’ve got this big buffer, not a geared buffer. That’s fantastic.”

Even the 2.75% fee associated with the notes was “reasonable,” being less than 1% a year, he added.

“Really the only issue we have with this note is the index,” he said.

Sluggish return

First Kalscheur said the performance of the U.K. benchmark has been subdued with a 7.13% annualized return over the last five years. But the index has a 3.96% dividend yield, he noted.

“So the actual growth itself has only been 3% a year. Nothing to write home about.”

Technology shows a 1.14% weighting, he noted with surprise.

“Technology in the S&P is the biggest allocation. Here it’s the smallest. That’s not promising in terms of growth.

“When you’re betting against IT, you’re betting against Amazon, Apple, Facebook, Netflix. I wouldn’t want to take that bet,” he said.

Financial dynamite

Second, Kalscheur said he was wary about the high concentration of financial stocks, which represent the No. 1 sector with a 21% weighting.

A contagion effect was likely if large banking groups in the euro zone continued to be under pressure, he noted.

“Banks in the U.K. could find themselves in a position to be guilty by association,” he said.

“There is a lot of cross-ownership in the banking industry.

“Being in the U.K. is not going to protect you from a financial crisis. It’s going to drag down this index.”

High opportunity cost

Perhaps Kalscheur’s main objection about the notes was the high cost of foregoing dividends.

“If you give up 4% a year for three-and-a-half years, you bet you’re going to get amazing terms,” he said.

If the total return of the index was 10% a year, which is Kalscheur’s expectations from equities in general as an asset class, the notes would generate about 12.5% a year.

“That’s acceptable. But I’m not convinced you can get this type of performance from this index,” he said.

Not the most efficient market

Part of his view derived from his reading of Morningstar ratings showing that funds tracking the S&P 500 index are very “efficient” as they outperform actively managed funds in a consistent way.

“In Europe, it’s harder to make this argument. I think over there, you’re better off investing with managers who know what they’re doing.”

A skeptical market outlook as well as the high dividend yield of the index contributed to disappoint this adviser.

“The financial issue is a significant concern.

“The technology exposure is almost non-existent. You’re almost betting against growth.

“I don’t like the index so much. All these factors sort of ruin it for me,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48129MZC3) will price on June 26 and settle on June 29.

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