JPMorgan’s contingent income autocalls on Pioneer Natural offer eye-catching barrier, vol. play

By Emma Trincal

New York, May 1 – JPMorgan Chase Financial Co. LLC’s contingent income autocallable securities due May 4, 2023 linked to the common stock of Pioneer Natural Resources Co. show an unusually low barrier for coupon payment and repayment of principal, which reflects the high volatility of the underlying, said Tim Mortimer, managing director of Future Value Consultants.

It is common to see 60% barriers on some stocks, allowing for an underlying price decline of up to 40%.

It’s quite different to see a 40% threshold giving a 60-percentage point range of contingent protection, according to data compiled by Prospect News.

If the shares close at or above the downside threshold level, 40% of the initial share price, on a quarterly determination date, the notes will pay a contingent payment that quarter at an annualized rate of 20%, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par of $10 plus the contingent coupon if the shares close at or above the initial share price on any quarterly determination date other than the final determination date.

If the final share price is greater than or equal to the downside threshold level, the payout at maturity will be par plus the final contingent coupon. Otherwise, investors will lose 1% for every 1% that the final share price is less than the initial share price.

“We don’t see that many 40% barriers,” said Mortimer.

“But obviously it’s a function of the volatility of the underlying stock.”

Investors should not be fooled by the position of the barrier but always consider the implied volatility of the underlying first.

“For an index like the S&P, the equivalent barrier would probably be 70%.”

Big sell-off

Pioneer natural Resources, an oil and gas exploration and production company, has seen its share price plummet by more than 45% this year.

Most oil stocks, especially the explorers, have tumbled over the past two months as crude oil price collapsed.

Friday morning, West Texas Intermediate crude futures traded below $19 a barrel, a drop of nearly 60% since the beginning of March when a price war between Saudi Arabia and Russia began.

During that time, the stock dropped by a third.

Volatility, call

The implied volatility of Pioneer Natural Resources is 51.2%, according to a report on the notes generated by Future Value Consultants.

“The stock is very volatile. But keep in mind that volatility and falling stock prices are not entirely the same. Yes, when the stock goes down, volatility increases. But it increases for other reasons, not necessarily because the stock has fallen so much.

“It’s the volatility that directly affects the pricing, not the price drop,” he said.

Another factor impacting pricing is the absence of call protection.

“It can get called right away, after three months. Therefore, the chance of calling is a lot higher. It’s not quite as attractive and so it will affect pricing.”

When that is the case, the issuer is able to provide a higher coupon.

Scorecard

Future Value Consultants offers stress-testing reports of structured products. The tests are based on a Monte Carlo simulation displaying for each outcome a probability as well as average payoff and duration.

A total of 29 tests are included in each report, which the firm’s clients can choose from and use in any combination.

The Monte Carlo simulation is based on hypothetical growth rates and volatility levels applying to the underlying.

One of the most used tables is the investor scorecard.

It shows probability of occurrence for three outcomes: the automatic call at various dates; the probability of getting “full capital return”; and the chances of a “total return loss.”

Another scenario labelled “capital loss but total return at or above capital” is displayed in the scorecard as with all similar products. But in the case of this particular note, it will show a 0% probability.

“This just can’t happen because your maximum income is 60% and you would have to drop more than 60% to incur a capital loss. So even with full coupon payments there is no way you could end up at or above capital,” he explained.

“With other structures, the result would be different. But in this case, it is irrelevant,” he said.

Early redemption

Mortimer first looked at the call scenarios.

The scorecard showed a 47.87% chance of an automatic call in August, which is the call at point 1.

The scorecard uses the base case scenario, also called neutral, which is the basis of the simulation in all reports. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

“This is pretty standard for those Phoenix autocalls, especially under the neutral scenario. You get a 50/50 chance of a call at point 1.”

The call probabilities rapidly decrease with time. For instance, there is a less than 12% probability of a call on the second observation date (after six months) and less than 6% for the ninth month, followed by about 3.5% after one year. After 2¼ years, the probabilities of calling fall below 1% to finish at 0.52% on the last call date.

Risk and duration

Outcomes when the notes are not called also provide indications about the riskiness of the notes and the potential payoff.

“You have a 23% chance of still being in the structure until maturity,” Mortimer said.

This probability is the sum of two outcomes: a 6.66% chance of full capital return and a 16.2% probability of total return loss, which combined make for 22.86% rounded up to 23%, according to the scorecard.

“You have a 6.66% chance of getting your full principal back irrespective of the coupon you may get. But you also have a 16.2% chance of losing principal.

“This shows how risky the position is if you don’t call and reach maturity.”

“You have a 23% chance of not calling and of that, more than two-thirds represent a capital loss.”

He was referring to the 16.2% bucket of total return losses out of the 22.86% chances of holding the notes to maturity.

“You may have a nice 40% barrier, but the barrier doesn’t feel so good if you’re not called. You’ll now have a 70% probability of losing money when that happens.”

Even the odds of never seeing the notes called, at 23%, were “quite high” and indicated a high level of risk, he added.

Big losses

In terms of loss amounts, investors will get less than 40% of capital returned (39.9%) on average if the barrier is breached, according to the average payoff column in the scorecard.

“And that is your average return even if you include the income, which is pretty bad,” he said.

“Overall, this is a pretty risky note. But with the high volatility of the stock and the high coupon, you would expect significant risk.

“You have a very good chance of calling early, but if you’re not, if you hold the notes until maturity, the chances of losing a significant amount of capital increase rapidly.”

Tactical bet

The best outcome for investors it an early automatic call, at least from a risk-reward standpoint, he said.

The deal may appeal to investors who see the oil market rebounding from its current lows.

In fact, the share price of Pioneer Natural Resources has already surged by 28% in April. But for the year, the stock is still down and remains undervalued.

“It’s a tactical opportunity to play the recovery in the sector.

“If you think the disruption in the oil market due to the coronavirus is only temporary and if you have the willingness to take on risk, this is a good time to catch the volatility and buy a structure like this,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent. Morgan Stanley Wealth Management is handling distribution.

The notes priced on Friday and settle on May 6.

The Cusip number is 48132L707.

© 2015 Prospect News.
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