JPMorgan's 7% autocallable yield notes linked to ETFs, index are on low end of risk spectrum

By Emma Trincal

New York, Nov. 15 - JPMorgan Chase & Co.'s autocallable yield notes due Feb. 23, 2015 linked to the iShares MSCI Emerging Markets index fund, the iShares MSCI EAFE index fund and the Russell 2000 index offer a reduced level of risk, mainly because of the volatility levels of the underlying assets, said Eve Berlinska, structured products analyst with Future Value Consultants.

The interest rate is expected to be at least 7% and will be set at pricing. Interest will be payable monthly, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus accrued interest if each component closes at or above its initial level on any quarterly call date.

A trigger event will occur if any component falls below its initial level by more than the 30% buffer amount on any trading day during the life of the notes.

The payout at maturity will be par unless a trigger event occurs and the return of the worst-performing component is negative, in which case investors will share in the losses of the worst-performing component.

Income product

The notes belong to the "review reverse convertible" category under Future Value Consultants' methodology.

"Investors get a fixed return just like in a regular reverse convertible. The difference is that the notes can be automatically called," she said.

"The return is not contingent upon the performance of the underlying assets. No matter what, investors are going to receive the 7% annualized coupon, or 1.75% per month."

Another characteristic of the notes and one seen with most reverse convertibles is the type of barrier - in this case called "American" - which can be triggered any day during the life of the notes. The other type - a European barrier option - is when the observation occurs only at the end of the term, she explained.

"This is a product designed for people looking for higher yield. It's a typical income type of product," she said.

Other income products, which do not fall into this product type, offer a contingent coupon payable only if the underlying closes above a certain trigger on a periodical basis.

"This is a separate category. For the purpose of this product, the main features are the fixed coupon and the autocall," she said, referring to the "review reverse convertible" terminology used by her firm.

"Those notes are very often tied to single stocks. The fact that this one is not tied to a stock makes it a little different and will be the main reason why the risk is moderate."

Products in that category, when not linked to stocks, often use a "worst of" feature, as it is the case with these notes.

In order for the notes to be called, all three underlying components must be at or above their respective initial levels, according to the prospectus. On the other hand, it only takes one of the three to breach the barrier on any trading date.

Despite this type of payout, the notes are on the lower end of the risk scale, she said.

Low risk profile

The risk of a debt instrument has two components: market risk and credit risk, she explained.

Future Value Consultants rates the risk with its riskmap. The riskmap measures on a scale of zero to 10 the risk associated with a product with 10 the highest level of risk possible. The riskmap is the sum of the two risk components.

The riskmap of the notes is lower than average for this type of structure, she said.

"It's because the market risk is much less than the average while the credit risk, even though a bit higher, is still rather contained," she said.

Credit risk

The credit riskmap for the notes is 0.36 versus an average credit riskmap of 0.30 for products of the same type.

"The main reason here is the term, "she said.

"This is a 15-month autocallable income note, and most of those products don't go beyond one year. The result is a credit riskmap that's slightly higher, but the difference is not significant. We can easily rule out credit as a factor because this issuer has spreads that are comparable to others - 85 basis points for the five-year CDS swap spread compared to 78 basis points for UBS and 75 for HSBC."

Market riskmap

There is a wider gap between the market riskmap of the notes and the average market riskmap at 1.78 and 3.32, respectively.

"This shows that the product is substantially less risky than its peers and that the risk of losses is less. The main reason is volatility," she said.

"Most of those products are tied to single stocks, which by nature are much more volatile. In fact, a lot of those notes can be linked to highly volatile stocks in order to boost the coupon. What we have here are not stocks but two funds and one index, all of which are much less volatile."

The implied volatility of the iShares MSCI EAFE index fund is 15%. The volatility of the iShares MSCI Emerging Markets index fund is 21%, and it is 20% for the Russell 2000.

Volatility

"The low market risk is almost entirely due to this volatility gap," she said.

"I wouldn't attribute it to the barrier level, although you can see barriers at the 75% or 80% level, which imply more risk. But a 70% barrier is still pretty much average. It's not going to make a notable difference in the scores.

"The type of barrier used, the American barrier that we have in this product, is also pretty common for this category of notes. American barriers are more risky, but they're widespread, therefore they won't help justify the gap with the average."

The "worst of" feature of the payout does not have a great impact on the scores either, she said.

"In theory, it should make the product more risky. But you have to take into account a series of other factors such as the volatility, the barrier level, etc., which play a bigger role. Their combined effect can offset the negative impact of the worst of," she said.

The low volatility factor can reduce risk by decreasing the chances of a barrier breach, she noted.

It also has a risk-mitigating impact as it increases the odds of an early redemption.

"If you get kicked out, the risk disappears. You get your principal back and the investment has ended," she said.

With such a lower-than-average market riskmap, the risk profile of the product is very low. The riskmap (or the sum of the two components) is 2.14, compared with 3.63 for the average.

"Much of the lower risk again is a function of the lower volatility seen in each underlying compared to stocks," she said.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios. In this case, the low-volatility scenario is the best. It is therefore the one used to compute the rating.

The notes have a 6.82 return score. In comparison, the average score for products of the same type is 6.19.

"This is a risk-adjusted score. What it means is that for the same risk level, the return offered by this product is better than what you can get with similar products," she said.

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10.

This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes have a 7.91 price score. In comparison, the average for this type of structure is 6.41.

"The price score is very attractive here," she said.

"The issuer spent more on the options compared to similar deals. The value of the assets is higher. The investor gets good value for his investment."

Overall score

Finally, the overall score measures Future Value Consultants' general opinion on the quality of a deal. The score is simply the average of the price score and the return score.

At 7.36, the notes offer a higher overall score than the average overall score for review reverse convertibles, which is 6.30.

"It's a great overall score," she said.

"The product offers very good terms for the risk taken. The notes are designed for someone who wants income but who is prepared to see the notes shortened by a call. Investors in those notes would actually hope for an early exit and would be prepared to take advantage of the reinvestment opportunity if the kick out occurred.

"Alternatively, they would settle for the coupon offered by the product if the call was not achieved."

J.P. Morgan Securities LLC is the agent.

The notes will price Tuesday.

The Cusip number is 48126NC47.

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