JPMorgan's $17.41 million 12.85% notes on MetLife via UBS reflect strong interest in financials

By Emma Trincal

New York, July 1 - JPMorgan Chase & Co.'s $17.41 million issue of 12.85% annualized yield optimization notes with contingent protection due Dec. 31, 2010 linked to the common stock of MetLife Inc. is one of many signs of the recent popularity of reverse convertible notes linked to financial stocks, sources said.

"It's my guess that volatility has been rising in the financial sector with the uncertainty going on in Washington and that high premiums are being sold for puts right now. Volatility in that sector makes these structures attractive," said Shana Orczyk, research analyst at Peak Financial Management.

Each note has a face value of $40.04, which is equal to the closing price of MetLife stock on the pricing date, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable monthly.

The payout at maturity will be par unless the final price of MetLife stock is less than 75% of the initial share price, in which case the payout will be one share of MetLife stock.

Popular name

There have been 10 deals using MetLife shares as the underlying this year, including this one, with Barclays Bank plc issuing almost all of them. The JPMorgan new issue is the biggest MetLife deal this year, according to data compiled by Prospect News.

The second-largest reverse convertible deal tied to MetLife was brought to market last month by Deutsche Bank AG, London Branch. The bank priced $7.01 million of 11% annualized yield optimization notes with contingent protection due Dec. 22, 2010 with a trigger price of 65% of the initial share price.

Financial June

In general, June saw a multiplication of reverse convertible offerings linked to financial or bank shares. Agents priced $162 million of such deals, or 7% of the $2.32 billion volume in June.

Sources attribute the uptick to a surge in volatility in the financial sector as the outcome of the financial reform examined in Congress remains unclear. They also believe that implied volatility is likely to decline once the legislation is voted on. Investors tend to buy reverse convertibles on the view that volatility is declining as it reduces the odds that the underlying stock will decline below the trigger price.

Trading sideways

Investors in reverse convertibles seek stocks they believe will trade sideways. As stated by the prospectus, the notes represent a "tactical investment opportunity" for investors who believe that the shares of MetLife will not move up by more than the coupon and that they are unlikely to fall by more than the 25% contingent protection.

"The coupon does not depend on the performance of the stock," said a market participant. "For people who believe that the price is not going to move up or down drastically, this is a good way to get some income."

The risks

The prospectus stated that the notes are not suitable for investors who are bullish on the stock or for those who seek 100% protection of their capital. Similarly, investors who do not want to be exposed to the same unlimited downside risk as a direct investment in the stock are not a good fit, according to the prospectus.

Steve Doucette, financial adviser at Proctor Financial, said that he would not invest in the product based on some of the risks described in the prospectus.

"I'm not a big fan of single-stock deals, but my problem is really the risk/reward here: You get 12% upside but with a limited downside," Doucette said.

"You're trading a coupon for a 100% equity risk because you can lose your entire principal. Is the risk/return offering a good balance?"

Doucette said that he preferred structures with a buffer that limits the amount of losses on the downside. For instance, a note with a 25% buffer would give investors the guarantee to get at least 25% of par back while the 75% remaining would be capital at risk.

With JPMorgan's note, a 30% decrease of the underlying shares would cause a 30% loss of principal since after the breaching of the barrier, investors get paid in shares of MetLife, he noted.

On the other hand, in some other structures, a 25% buffer would absorb some of the losses, capping for instance a 30% decline of the underlying price to a 5% loss in principal.

"I guess the question is: Can I collect the coupon in the worse-case scenario? Instead of 6% for the six months, I may just collect 2% or 3% depending on how the share price ends up to be," Doucette said. "This comes with a lot of risk."

Protective coupon

The prospectus, however, said that the coupon is paid regardless of the stock performance and is designed to "compensate" investors for the possibility of losing their entire principal.

In that regard, the coupon may be viewed as the equivalent of a protection, the market participant noted.

"Money is money. Minor details aside, economically a coupon is the same as principal," he said.

The prospectus illustrated this with an example using the $40.04 initial share price. Assuming a 60% decline in the stock price, the closing price of MetLife on the maturity date would be $16.02. However, the investor would still receive six months worth of his coupon, or $2.57. At maturity, what the investor would collect would not be $16.02 but $18.59. So instead of losing 60% of principal, the investor would in fact lose 53.57%, according to the prospectus.

'Just a fancy put'

Some market participants said that the notes make sense for someone who anticipates a limited decline of the stock and who would want to get exposure to the stock.

Orczyk said that such a strategy can be achieved at a lower cost and with less risk with options than with the note.

"If you want the stock and believe that it won't go down beyond the 25% threshold, you want to sell a put. In both cases you get some income either as a monthly coupon or as a premium. In both cases you get put the stock when the share price drops below the strike," Orczyk said.

Talking about reverse convertibles in general and this deal in particular, Orczyk said, "It's just a fancy put."

Orczyk said that selling a put is also an income strategy for investors who are not overly bearish on the stock.

She took the following example: The initial stock price is $40.00. With a trigger price set at 75% of the initial price, the strike price is $30.00.

She looked at December put options for a $30.00 strike price and found a $2.38 premium for those contracts.

The premium divided by the initial price is the equivalent of a 5.95% return, she said.

"I write a put. It gives me the obligation to buy it at the $30.00 strike price. If MetLife shares end up higher than $30.00, I haven't lost anything. It's the equivalent of getting my principal back. If the stock price goes below the strike price, I'm being put the stock and I have to buy it at the strike price, which is higher than what it's trading at. That's the equivalent of losing some of my principal when the notes pay me in shares at maturity," she said.

Orczyk compared the 5.95% return a put seller would obtain with the 6.42% coupon collected by an investor in the notes during the six-month period.

"Yes, the option strategy gives me a slightly lower coupon because banks get better pricing as they buy options in bulk," she said. "But my options strategy comes with more liquidity, as you can sell a put anytime. In addition, the option will cost you less and you won't be subject to credit risk," she said.

UBS Financial Services Inc. and J.P. Morgan Securities Inc. are the underwriters.

Fees are 1%.

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