JPMorgan’s autocallable contingent coupon notes on indexes provide high yield, no S&P exposure

By Emma Trincal

New York, June 26 – JPMorgan Chase Financial Co. LLC’s autocallable contingent interest notes due April 5, 2021 linked to the least performing of the Dow Jones industrial average, the Nasdaq-100 index and the Russell 2000 index offer a double-digit coupon based on three major U.S. equity benchmarks. Uncharacteristically, the S&P 500 index is missing.

The notes will pay a contingent monthly coupon at an annual rate of 14.5% to 16.5% if each index closes at or above its 70% interest barrier on the related monthly review date, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if each index closes at or above its initial level on any monthly review date other than the first, second and final ones.

The payout at maturity will be par plus the coupon unless any index finishes below its 70% trigger level, in which case investors will be fully exposed to any losses of the worst performing index.

No S&P

“There are many worst-of autocallables on three indexes. But you almost always have exposure to the S&P. It’s quite unusual not to have it,” said Tim Mortimer, managing director at Future Value Consultants.

“This product is based on three of the mainstream indexes, and it pays a high coupon. Those indexes are quite more volatile than the S&P. That’s how you get the extra value.”

The non-inclusion of the S&P 500 index may offer other advantages.

“Investors have large allocations to the S&P either through notes or directly. Here you get a little bit of diversification,” he said.

“For investors it’s still a play on American markets. They recognize those indexes, and they’re probably happy with it.”

Correlations

Future Value Consultants offers stress-testing on structured notes. The research firm produces reports providing simulation tables as well as back-testing analysis.

The correlation matrix in the report generated for this product revealed that the greatest correlation is between the Dow Jones industrial average and the Russell 2000 (94.9%) while the Nasdaq and the Russell displayed the lowest correlation at 91.61%.

“The difference is not huge, but it shows a higher correlation between indexes that track the entire economy rather than between indexes of similar market capitalizations,” he said.

“The Dow represents large stocks across all sectors; the Nasdaq, large stocks in the tech sector only; and the Russell, small-caps across all sectors.

“It’s the broad exposure to all economic sectors that appears to drive the correlation here.”

Tenor

The nine-month maturity is relatively short, he noticed. One reason may simply be investors’ preference.

“Most people don’t want to think too far ahead. Nine months is probably a reasonable horizon in the current market cycle,” he said.

The short maturity also allows for a higher coupon, he said.

“For all yield-based products with principal-at-risk, like reverse convertibles for instance, the coupon is higher on short maturities,” he said.

That’s because a short-term option will give more premium on a per annum basis.

“The risk of an option doesn’t go up proportionally with time. So, if you go from one year to two years, the put you sell to finance the coupon is not twice as expensive. Its price grows but it grows slower.”

“This is why a short-term option will give you more value,” he said.

Call probabilities

Each report contains several sections or tests based on volatility and growth rate assumptions.

One of those reports – the scorecard consists of different mutually exclusive outcomes of product performance. It shows probability of occurrence, average returns and average durations.

Probabilities of calls at various “call points” are relevant to make a buying decision for investors considering investing in an autocallable note.

The report showed a 45.92% chance for the notes to be called on the first call date, which is after three months.

“It’s quite high. As usual, it falls after that. But in this case, the probabilities fall drastically,” he said.

There is only an 8.76% chance of a call on the second call date, which is only one month later, he noted.

The probability for the second call is usually a third of that of the first call. On average, a call at point two should therefore be closer to 15.3% than 8.76%.

Outcomes at maturity

The scorecard displays other outcomes.

One of them named “capital loss but total return at or above capital,” represents a scenario in which the barrier is breached but the amount of paid coupons is enough to offset the losses.

A probability of 0% is associated with this outcome in the case of this product. That’s because the sum of all coupons cannot be as high as the 30% minimum amount of loss, which may occur upon a barrier event.

Another important outcome is the “total loss” at maturity. The scorecard assigns to this scenario an 11.52% probability.

A third outcome would be when the price finishes negative but above the barrier. In this case, there is neither a call nor a loss. Investors fully benefit from the barrier protection in this situation.

The simulation showed an 18.58% probability associated to this outcome.

“If you add this scenario to the total loss bucket, the notes will not be called 30% of the time,” said Mortimer.

Calls, losses

While the chances of avoiding the call appear high, the chances of losing capital are fairly low, he noted.

“In order to lose capital, the underlying price has to finish below the 70% barrier in nine months. Also, the note can’t be called on any of the monthly call points.”

These factors indicate that the investment was not among the riskiest in that category of products.

The tail risk is not eliminated, however. If the barrier is breached, the average loss will be 40%, according to the scorecard.

But this is in line with the amount of conditional protection implying a minimum loss of 30%.

“It’s a worst-of, so you need some tolerance for risk. All three indexes need to be above the barrier in order to collect the coupon and to get your principal back,” he said.

“The notes are linked to diversified, well-known indexes. You have high chances of calling, especially early on, and a relatively low probability of losing capital,” he said.

Back-testing

The report also provides back-testing analysis over three timeframes: the last 15, 10 and five years.

During the last 15 years, the back-testing showed a 3.19% frequency of losses. But the rate was 0% over the past 10 years as well as over the last five years.

“The Lehman crisis is no longer in the 10-year bucket. Only the 15-year back-testing fails and that’s because it still goes back to that time,” he said.

“The effect of the Great Recession is starting to drop off the back-testing for the past 10 years.”

The barrier level contributes a lot to limiting the risk in the product, he said.

“A 30% barrier is quite significant for a nine-month deal.

“For investors who believe the U.S. markets are not going to drop more than 30% in nine months and who want a fairly high coupon, it seems fairly reasonable,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price on June 30.

The Cusip number is 48132MC41.

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