S&P 500-linked autocallables could underperform, but 50% cash is a better gauge, analyst says

By Kenneth Lim

Boston, July 24 - Holders of equity-linked autocallables may do better if they had bought directly into the underlying indexes because of the recent market run-up, but that may not be the best way to understand those products, said structured product analyst Tim Mortimer of Future Value Consultants.

JPMorgan Chase & Co. in January priced $5.07 million of semi-annual review notes due Feb. 16, 2011 linked to the S&P 500 index.

The notes will be called on July 30, 2009 at a redemption price of 108.7% of the principal if the S&P 500 closes at or above 743.29. That represents 90% of the S&P 500's initial level of 825.88 at pricing.

If the notes are not called on July 30, they may be called at a 17.4% premium on Feb. 12, 2010, at a 26.1% premium on Aug. 12, 2010 or at a 34.8% premium on Feb. 11, 2011 if the S&P 500 closes at or above its initial level on any of those call review dates.

If the notes are never called, investors will receive par or lose 1.1111% of the principal for every 1% decline in the index beyond 10%.

Going as planned

As Future Value described in its report on the JPMorgan product, the chances of the autocallable getting knocked out is highest at the earliest review dates.

Investors had an 81.3% probability of getting called with the product, Future Value estimated. Overall, the product got a high 7.31 rating out of a best possible 10.

The S&P 500 closed at 979.26 on Friday, about 18.6% above its initial level, which suggests that the product will likely be called. It also means that investors will probably underperform the index. But that may not be a good way to judge the product, Mortimer said.

"It's easy to say that, obviously," he said. "But this product would have paid you 8%, against the background of cash that's next to nothing, and even if the market's down 10%, so that's pretty good."

Investors who buy review notes should never expect to match an underlying performance that is off the charts, he added.

"A structured product with a capped upside can never keep pace with a strong positive performance in the underlying," Mortimer said.

Correct benchmarks

Although the autocallable's returns are linked to the S&P 500, the equity index alone should not be a performance benchmark for the product, Mortimer said.

"A better benchmark may be a hybrid benchmark that is 50% in cash, 50% in equities," he said. "And if you do the calculations there, then this product matches that benchmark over that time frame."

As an investment instrument, the autocallable is similar to an income-yielding investment that pays an 8% return as long as the underlying market does not fall more than 10%.

"You can compare it to perhaps a corporate bond fund where 10% is perhaps like your ability to suffer a credit quality downgrade," Mortimer said.

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