JPMorgan's buffered leveraged notes tied to EAFE ETF aim at risk-averse investors, mild bulls

By Emma Trincal

New York, June 2 - JPMorgan Chase & Co.'s 0% capped buffered return enhanced notes due June 30, 2016 linked to the iShares MSCI EAFE exchange-traded fund offer a buffer and a cap on a short-term investment horizon, making the notes a good fit for defensive portfolios as well as investors with a mildly bullish view on the European recovery, sources said.

A bet on the iShares MSCI EAFE ETF, which tracks the MSCI EAFE index, the benchmark for developed countries outside of the United States and Canada, is often seen as a proxy for an investment in European equity, sources said. That's because more than half of the index's regional constituents are Western European countries, according to the iShares website, with the United Kingdom and France making for 18% and 10%, respectively. The largest allocation is Japan with a 19.32% weighting.

The payout at maturity will be par plus 1.75 times any gain in the fund, up to a maximum return of 15% to 19%. Investors will receive par for losses up to 10% and will be exposed to any losses beyond the buffer, according to an FWP filing with the Securities and Exchange.

The 15% to 19% cap range with a 1.75 leverage factor represents an annualized compounded return of 7.25% to nearly 11%.

Defensive

For Carl Kunhardt, wealth adviser at Quest Capital Management, the notes are adapted to a risk-averse portfolio. However, a bullish investor should not consider the product.

"It's a little bit of a mixed bag," he said.

"If I had to decide where to put it, I would probably choose my conservative portfolios rather than my aggressive ones. Regardless of the style, you do need international exposure. But for a conservative investor, the problem with EAFE near-term - and we're only talking about a two-year [note] - is that you're going to get significant volatility.

"I am bullish on Europe, and this index is a bet on Europe for the most part.

"But just because the Europeans are doing the right thing right now - they're doing exactly what we did in 2009 and 2010 - does not mean all the problems in Europe have been solved. If they don't move forward with rate cuts, the whole house of cards will collapse. I think that they will. They've seen that more accommodative policies worked for us and that it worked in Japan.

"And yet, I expect that there is going to be material volatility in the EAFE for the next two years."

Reducing volatility

One way to have exposure to Europe while mitigating risk is to consider a structured note, he said.

"Getting the exposure with this one addresses part of the volatility problem," he said.

"The 10% buffer is a big help. Your first 10% are covered.

"You have a cap. But if we're talking about a conservative portfolio, the cap is less of an issue.

"And you also don't have the ups and downs because it's point to point.

"This is something that gives conservative clients a way to participate in that market without necessarily exceeding their risk tolerance parameters.

"For all these reasons, I see it as a viable addition to a conservative portfolio."

The same could not be said for more aggressive plays in Europe.

"If you're bullish on Europe, if you're bullish on developed markets, this is not the right note," he said.

"Someone like me who is bullish on Europe is less concerned about the buffer. I really don't want the cap.

"I see this note as a conservative way to get my international exposure. But I wouldn't use it in an aggressive portfolio because of the cap."

Jim Delaney, head trader at Market Strategies Management, said the notes are expressly designed for investors betting on a subdued recovery in Europe.

He compared the notes with a direct investment in the fund.

Single-digit returns

"The question is, do you buy the structured note to get the leverage and the buffer, or do you buy the index that has no upside limitation?" he said.

"In order to buy the index, you have to believe that you won't get a return higher than 17% in two years."

Delaney assumed a 17% two-year cap at the mid-point of the range. This level offers roughly 8% per year on a compounded basis.

"It's a pretty good piece of paper for the retail investor. Why? My view is that in Europe, everything is getting better but nothing is really getting better as quickly as everybody thought at the beginning of the year," he said.

"People are starting to question the strength of the European recovery. This year might be single-digit. The year as a whole is not showing a strong performance. In the U.S., we're positive, but it took us a while this year."

Disappointing growth

Delaney pointed to the upcoming decision by Mario Draghi, president of the European Central Bank, on Thursday about interest rates.

"He has been advocating a monetary stimulus. Whether he cuts rates or not, the fact that he's been talking about it shows that he's not happy with growth," he said.

"The recovery in the euro zone as the market expected it may not happen."

For investors holding this view, the notes may represent a suitable investment.

"The leverage would be useful because you may need some help. The index is not going to give you 8% a year for the next two years," he said.

Mildly bullish

Being mildly bullish, however, does not mean investors are concerned with market risk, he noted.

"It's nice to have a downside buffer. I don't think you're going to need it though. At this stage of the recovery, if we need a buffer, then the whole world has got bigger problems. I don't think the buffer adds much value. But it's nice to have it. It's always good to have a little bit of insurance," he said.

The cap level is appropriate for moderate bulls, Delaney added.

"This note expresses a mildly bullish view on the European recovery. You don't expect a double-digit return, but there is still some growth, which makes the buffer not necessarily useful, although it's always good to have it.

"The leverage is good. The cap is tolerable. It's high enough for the growth you would expect in this scenario.

"Both the buffer and the leverage help you gain the advantage versus the index itself, but only in a mild recovery scenario."

The notes (Cusip: 48127DKU1) will price June 25 and settle June 30.

J.P. Morgan Securities LLC is the agent.

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