JPMorgan’s $7.25 million barrier notes linked to EAFE ETF set new record with 11x leverage

By Emma Trincal

New York, Jan. 20 – Leverage is the most popular structure, but sellsiders were caught off guard when they saw the pricing last week of a leveraged note with an 11 times leverage factor.

JPMorgan Chase & Co. priced $7.25 million of 0% capped contingent buffered return enhanced notes due Jan. 19, 2018 linked to the iShares MSCI EAFE exchange-traded fund.

If the final share price is greater than the initial share price, the payout at maturity will be par plus 11 times the ETF return, subject to a maximum return of 20%, according to a 424B2 filing with the Securities and Exchange Commission.

If the ETF falls by up to 30%, the payout will be par. If the ETF falls by more than 30%, investors will be fully exposed to the ETF’s decline.

Because of the 11 times leverage factor, investors will hit the cap if the ETF appreciates by more than 1.81818%.

“Is this a joke?” a New-York based structurer asked.

The note sets the record for high leverage in the equity asset class, according to data compiled by Prospect News.

The database tracks all structured notes registered with the SEC since Jan. 1, 2007.

The previous record-holder was Credit Suisse AG’s $1.85 million of two-year notes linked to the S&P 500 index with a 10 times upside multiple in February 2009. The cap was at 5.2%.

A lot of leverage

“Eleven times on an index. It seems like a lot to me,” a market participant said.

“Even with the highest dividend ratio on earth it wouldn’t be enough to make 11 times.”

The MSCI EAFE index, which tracks equity returns of developed countries excluding North America, has a 2.75% yield.

“The way they do that of course is with the 20% cap, making this some kind of digital option,” he said.

“Since the fund needs to go up by less than 2% for investors to get the maximum return, either you get 20% or you get zero or you can even lose money if you’re below the barrier.

“Still ... it seems like a lot.

“Never in my life have I seen that kind of leverage on an equity note.”

In the foreign exchange market, such high participation rates on the upside are much more common, he said.

Data compiled by Prospect News confirmed the existence of comparable leverage numbers with currency underliers and also with some rates.

An FX thing

“In the FX it can be done. It really depends on the carry,” he said.

Carry refers to the spread between borrowing a low-yielding currency and investing in high-yielding currencies.

“With some currencies you can have a gigantic carry. Take the Russian ruble for instance. It’s plunging. A dollar is now 82 rubbles.”

The Russian ruble fell to an all-time low against the dollar on Wednesday.

“You can get an 11% yield right now from this carry. Borrow in dollars with yields close to nothing and buy the rubble.”

A reason for the divergence between the FX and equity asset classes when it comes to pricing leverage is the cost of the options, said a currency trader.

“Volatility in the FX market is lower than in equities if you compare the premium on the same tenor. So leverage is cheaper. You can buy more calls,” he said.

“Also the skew in FX is more prominent than in equities. Futures prices on equity are not too much different from spot prices. In FX, the forward market is very different from the spot.”

He explained that investors in FX notes can obtain substantial yields by taking the opposite view and getting handsomely paid for betting against a rising currency such as the dollar and taking long exposure on a declining currency.

“You can generate a package that’s very cheap.”

But providing very high leverage out of the equity market poses a much greater challenge, he noted.

Still, this trader, who prices exotic structured notes, said it is not impossible.

Barrier, rates

“I’m not necessarily surprised with the 11 times. It’s a knock-out option, which can cheapen the option,” he said.

He was referring to the barrier. Once the underlier hits the barrier threshold, the protection disappears, which makes it less expensive than using a buffer.

“Also, we’re still in a low interest-rate environment. There is this global sell-off. Bond prices are rising in a flight to quality, keeping down yields.”

The 10-year Treasury began the year with a 2.24% yield. It fell below 2% on Wednesday.

Coupon-like

The New York structurer, who at first was shocked by the amount of leverage, said that the word leverage was almost a misnomer. The deal had to be looked at from a different angle, he said.

“Think about it almost like a reverse convertible with a contingent coupon,” he said.

“To reach your 20% cap, you need the index to go up 1.8%. Then you get your 10% coupon.

“A 1.8% rise isn’t much, but still ... the index does need to be up, otherwise the investor doesn’t capture the full coupon.

“In a normal phoenix autocallable, you get your coupon at a lower level, usually 30% or 25% below the initial price.

“Here the index actually needs to go up. It makes a difference.

“Even if it doesn’t have to go up much, it’s still harder to achieve than being above a 70% barrier. You get paid for that. That’s one of the reasons you can finance the leverage.”

Zero coupon

Another factor was the payment frequency of the coupon.

“Since it’s a leveraged note, you have to wait two years before receiving your coupon. It’s effectively a coupon deal except that you don’t get anything during the term. If you had a reverse convertible or a phoenix autocallable, it wouldn’t be that way. You would collect as you go.”

The barrier type did not play any particular role in boosting the leverage, in his view.

“The 70% barrier is just normal procedure. You sell that European knock-in put and use the premium to buy the digital,” he said.

“The 11 times leverage at first is very surprising, but I’m sure the pricing makes sense. People on the desk don’t misprice deals. They would get fired if they did.

“You just have to look at this product as a coupon deal, not so much as a leveraged deal.”

Others

Other prior highly leveraged equity notes, based on Prospect News data, include $5.09 million of 0% Accelerated Return Notes linked to the S&P 500 priced by Bank of America Corp. in 2010. The upside leverage was nine times up to a 220.59% cap over a 10-year term.

Four deals featuring eight times leverage also priced: one in 2011 from Deutsche Bank AG, London Branch and three last year, including two from HSBC USA, Inc. and one from Citigroup, Inc.

Aside from those notes and the recently priced JPMorgan deal, all equity deals priced over the past nine years have shown leverage factors limited to five or less.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48128GHZ6) priced on Jan. 14.

The fee is 0.5%.

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