JPMorgan’s dual directional barrier notes on two ETFs offer international equity bull play

By Emma Trincal

New York, Nov. 27 – JPMorgan Chase Financial Co. LLC’s 0% uncapped dual directional contingent buffered return enhanced notes due Nov. 30, 2022 linked to the lesser performing of the iShares MSCI EAFE exchange-traded fund and the iShares MSCI Emerging Markets ETF appear to offer benefits on the downside and the upside alike for those content to hold the notes during a five-year timeframe, buysiders said.

If each fund finishes above its initial level, the payout at maturity will be par plus 1.4 times the gain of the worse-performing fund, according to a 424B2 filing with the Securities and Exchange Commission.

If either fund falls but by no more than the 35% contingent buffer, the payout will be par plus the absolute value of the return of the worse-performing fund.

If either fund falls by more 35%, investors will lose 1% for each 1% decline of the worse-performing fund.

Good overall

Steven Foldes, vice-chairman of Evensky & Katz / Foldes Financial Wealth Management, said he liked the structure although he would make some changes to fit his investment objectives and style.

“This is a very interesting note. I congratulate JPMorgan for putting together such a clever, creative product,” he said.

“Some of the terms I like; some I don’t like; and some are unnecessary, which if I was doing this note, I would change it to make it even more attractive to our clients,” he said.

Tight spreads

On the positive side, he mentioned first the creditworthiness of the issuer.

“JPMorgan’s credit is one of the top ones in the U.S. with Bank of America. We have no issue with that,” he said.

JPMorgan and Bank of America each show five-year credit default swap spreads of 43 basis points, according to Markit. Closely behind are Citigroup and Wells Fargo with 46 bps. Morgan Stanley shows 55 bps and Goldman Sachs, 59 bps.

Pure bull

Foldes was particularly pleased with the uncapped upside.

“It’s very important to us. You’re talking about asset classes that have the potential of exploding, and you want to give the full upside benefit to your client,” he said, citing the performance of the two underlying funds. The iShares MSCI EAFE ETF is up over 20% this year while the iShares MSCI Emerging Markets fund has gained more than 30%.

“What you have are two markets that can be substantially higher given their attractive valuation compared to the domestic stock market. Since Brexit, the U.S. performance has been great but international developed and international emerging markets have been better.”

In addition, Europe and emerging market countries are still benefiting from monetary easing.

We’re raising rates. They’re not there yet. They’re earlier in the cycle. That’s an advantage.”

Worst-of structure

The use of a worst-of structure for uncapped leveraged return was an effective idea for this adviser, especially when the underliers are likely to move in sync.

“The worst-of obviously enhance the terms because you have two different exposures. But when you have a high correlation it mitigates some of the risk,” he said, taking note of a 0.75 coefficient of correlation between the two ETFs.

“There’s a high likelihood that you’re going to benefit even with the worst-of,” he said.

“We don’t dislike the worst-of so long as the correlation between the two is high, which it is here.”

Too long

The product however showed some weaknesses, according to Foldes, citing the long tenor as the most problematic one.

“Five years is simply too long for us. We would have to shorten it and look at alternatives without compromising the unlimited upside,” he said.

Another problem with a longer maturity is that the non-payment of dividends compounds over a longer period of time, which raises the opportunity cost of investing in the notes versus the funds, he added.

Among the two ETFs, the greater opportunity cost would be incurred if the worst-performing fund was the iShares MSCI EAFE fund as its 2.4% dividend yield is the highest.

Fee, barrier

Another drawback, according to Foldes, was the 3.5% fee.

“The pricing at 70 basis points [per year] may be a little bit high. But that’s a discussion we would have with JPMorgan,” he said.

What would lead Foldes to renegotiate the deal would be what he called “the unnecessary” terms of the structure.

Case in point: the 65% barrier over a five-year period.

“It looks good but it’s really unnecessary. Truth be told over a five-year period of time, the chances of a major asset class being down 35% is very low. You don’t need this protection. We would eliminate the protection and therefore the cost of the protection because we don’t believe you need it.”

Absolute return

Another piece Foldes said he could do away with was the absolute return.

“It’s attractive but again it’s unnecessary. In fact, we’d rather stay away from the absolute return because it could be pretty confusing for the client.

A client could gain 35% if the worst-performing fund was down 35% but lose 36% if it dropped an extra point.

“That’s dramatic. That’s a client communication problem I prefer not to have,” he said.

Reconstruction

To make the notes attractive to his clients, Foldes said he would want to shorten the term to a two year.

“We realize that going from five to two years would require some significant concessions. We would give up in its entirety the barrier even on a two-year and we would have a more modest buffer; we would give up most, if not all of the leverage with the goal of maintaining the uncapped return.

“If we have to choose between a buffer and a cap we would do away with the buffer,” he said.

Long is good

Michael Kalscheur, financial adviser at Castle Wealth Advisors, had a different perspective. His clients tend to be very risk-averse, and he prefers longer-dated products in general.

“We love longer maturities especially with no cap because you get the opportunity of compounding high returns,” Kalscheur said.

The leverage was good to have as “it will more than make up for the lack of dividends,” he added.

Watch those stocks

Kalscheur liked the international equity play given their lagging performance over the past few years at the exception of this year so far.

One risk however was the high concentration of certain riskier stocks in the emerging market fund. He cited the top three stocks, all belonging to the technology sector – Tencent Holdings Ltd., Samsung and Alibaba Group Holding Ltd. – and making 15% of the portfolio.

“It’s not a bad index. But any index is subject to market conditions. When you have concentration in sectors or names, it increases your risk of hitting the barrier,” he said.

Back testing

Kalscheur paid special attention to the barrier as his firm seeks defensive investments when using structured products.

He routinely looks at probabilities of return outcomes based on historical performance to assess the value of a protection offered in a structured note.

Unlike the S&P 500 index where he is in possession of over 30 years of historical records, the available data for the two funds goes back to a little bit over 15 years with his performance table starting in 2002 for the EAFE and 2003 for the emerging markets index.

“I’d like to have a longer track record, but at least we have a full cycle just finishing up the dot.com bubble and going through the 2008-09 crisis,” he said.

The result of his analysis showed that neither one of the two indexes has incurred a 35% decline in price since the early part of the last decade for any five-year trailing period.

Comfort zone

“It gives me a fairly high level of confidence that the barrier won’t be breached. The whole point for us to get into structured notes is not the upside potential. We want the upside. But we’re mostly focused on the downside protection,” he said.

“If this note only had a 20% barrier, I wouldn’t buy it. Even 25% would make me nervous.”

Kalscheur prefers buffers to barriers. But some cases are the exception such as with this product, which combine a long tenor and a sufficient amount of contingent protection.

“If I’m going to have a barrier, it’d better be a good enough barrier to make me sleep at night. This one is really good,” he said.

“Statistically speaking we should be in the clear. If the 35% doesn’t give you peace of mind, you should be looking at principal protection.”

Two out of three

The absolute return was not a must. But it could be valuable.

A 10% decline for instance would allow investors to outperform by 20%.

“This would add a huge benefit to a client without giving up anything for it,” he said.

In conclusion, Kalscheur said he can win two out of three times with this product, which is one of his selection criteria. If the market is “way up,” investors in the notes would outperform. If it declines significantly but not by more than 35%, investors would significantly outperform.

The only “losing scenario,” he said, is if the index gains are mediocre, in which case the lack of dividends plays against the noteholder.

“I’d be hard-pressed to find anything I don’t like about this note,” he said.

J.P. Morgan Securities LLC is the agent.

The notes are guaranteed by JPMorgan Chase & Co.

The deal will settle on Thursday.

The Cusip number is 48129HNB9.

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