JPMorgan’s return enhanced notes on MLP, commodity indexes to offer timely play with value

By Emma Trincal

New York, Oct. 23 – JPMorgan Chase Financial Co. LLC’s 0% capped buffered return enhanced notes due April 29, 2022 linked to an equally weighted basket consisting of the Alerian MLP index and the Bloomberg Commodity index intrigued two market participants, not only because commodities-linked notes have become rare but also due to the terms of the deal as well as the low price of the underlying assets.

If the final basket level is greater than the initial basket level, the payout at maturity will be par plus 1.25 times the basket return, subject to a maximum return that is expected to be at least 32% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the basket declines by 20% or less and will lose 1% for every 1% that it declines beyond 20%.

Unusual basket

“It’s unusual,” a market participant said.

He pointed to the specificity of the two basket components, one tracking commodities in general, the other, energy infrastructure Master Limited Partnerships or MLPs through the Alerian MLP index, which tracks them.

MLPs are publicly traded limited partnership, which offer the favorable tax treatment of private partnerships (profits are taxed upon distribution) combined with the liquidity of publicly traded companies.

MLPs are sought after for their income potential, he said.

The MLP Alerian index yields 8.4%, which is higher than most yields seen in income-heavy sectors such as utilities and real estate investment trusts.

The Bloomberg Commodity index is a broadly diversified commodities benchmark.

“It’s a basket but I don’t think people would buy it for diversification. It’s more to lever a package that includes two separate exposures. They do it in one note so they don’t have to make two different investments,” said this market participant.

Structure and dividends

What he found particularly “interesting” were the terms of the deal.

“It’s a pretty short-term note. It gives you 1.25 times the upside up to a 32% cap. That’s pretty compelling,” he said.

The cap is 11.75% per annum on a compounded basis.

As with any structured note however, holders do not receive dividends on the securities included in the index. Still, the terms remained attractive, he said.

“MLP indices tend to have high-dividend yields. You give that up but the result is very good pricing. You wouldn’t have those terms if you were long the index.

“Having a 20% buffer on the downside is a significant amount of protection.

“If you’re not worried about the downside risk, you’d want to take your dividends and buy the ETF.

“This gives you the downside protection while you can still express a view on the price return of the MLPs.”

Loving the unloved

Energy as a whole is the worst performing sector this year, according to Select Sector SPDRs, the exchange-traded funds that divide the S&P 500 into eleven sector index funds.

The Energy Select Sector SPDR is up 2.53% at the bottom of the list versus a gain of 30.2% for the Technology Select Sector SPDR. Energy continued to be the worst place to be in the S&P 500 index over the past month with a 4% decline.

This has gotten the attention of many value-seeking investors.

“A growing number of investors have the view that energy has been beaten down so much, now is a good time to get in,” this market participant said.

“You get in at a healthy entry price. This view is not as uncommon anymore. It’s not hard to see people betting on a rebound of the sector. From that standpoint, the notes with the leverage offer an interesting play.

“You’re not getting cheated for not having the dividends. You’re just getting something different.”

Dying asset class

The deal also caught observers’ attention as commodities-linked notes have become very rare in the U.S. structured products market.

On average only five commodities deals get priced each month for a total notional averaging $28 million, according to data compiled by Prospect News.

With $288 million sold this year so far, the asset class makes for less than 1% of total issuance volume.

Politics

Even outside the structured notes space, the upcoming offering attracted the attention of commodities market participants.

Emil van Essen, chief executive officer of Emil Van Essen LLC, a managed futures and energy trading firm, said he was very intrigued by the deal.

“MLPs and energy in general are ridiculously undervalued so that’s where the upside is,” he said.

“People worry about Democrats banning fracking. The elections could cause a tremendous amount of downside or upside.”

Futures yield curve

The other component of the basket, the broad exposure to commodities through the Bloomberg benchmark. was probably designed for diversification. The Bloomberg Commodity index diversifies across 23 different exchange-traded futures contracts on physical commodities in seven sectors.

With any exposure to futures contracts comes the risk of contango, he said, while downplaying it as not a major concern at the present time.

Contango is a condition in futures markets that may erode performance for investors long the contracts, he explained.

The futures contracts composing the Bloomberg Commodity index must be replaced by newer ones when they expire, a process called rolling. If the new contract to be purchased for a longer-dated expiration is going to cost more than the expiring one that needs to be sold, investors will incur what is known as a negative “roll yield,” a potential source of underperformance.

The opposite phenomenon – when the price of the nearer delivery month is higher than the distant delivery month – is called “backwardation. A futures curve when in backwardation offers a positive roll yield, which benefits any investor long the position.

Van Essen put the risk of negative roll in perspective.

“For most contracts, including crude, nat gas, the [futures] yield curve is pretty flat going out the next two-and-a-half years,” he said.

That would limit the risk of contango.

The main risk was by far the high volatility associated with the asset class and the potential for market-induced losses.

A bet on volatility

Can bargain hunters be attracted to commodities for the low entry price?

It depends on investors’ appetite for risk and how comfortable they feel about the buffer, he said.

To be sure, commodities are currently pricing at a bargain. The index is down 14% for the past year and flat this year. But it has fallen by close to 14% in the past three months.

“On the downside, you have this 20% buffer. If something really bad happens, say the index drops 50%, under this disaster scenario, you have 30% in losses not 50%. You could certainly hedge the rest,” he said.

“I find it interesting. It seems like this vehicle gives you a good ability to take advantage of the volatility in the market. It’s something I would want to investigate.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price Oct. 31.

The Cusip number is 48132FZA7.

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