JPMorgan’s buffered leveraged notes tied to Russell 2000 show fair terms but risky timing

By Emma Trincal

New York, June 2 – JPMorgan Chase Financial Co. LLC plans to price 0% capped buffered return enhanced notes due Dec. 11, 2017 linked to the Russell 2000 index, according to a 424B2 filed with the Securities and Exchange Commission.

The notes are guaranteed by JPMorgan Chase & Co.

The payout at maturity will be par plus double any index gain, up to a maximum return of 15% to 16.5%.

The exact cap will be set at pricing.

Investors will receive par if the index falls by up to 10% and will lose 1% for every 1% decline beyond 10%.

Plain-vanilla

Steve Doucette, financial adviser at Proctor Financial, said he liked the simplicity of the product.

“This is one of these plain-vanilla notes when you have the possibility of outperforming the index in either direction,” he said.

“If the market goes down you get the 10% buffer. If it goes up, you have the leverage. Might we get new highs taking us beyond the 10% cap? It’s possible. But is anybody going to complain with a 10% annual return?”

The 18-month note with its 15% to 16.5% cap range generates an annualized return comprised between 9.75% and 10.75% on a compounded basis. The underlying index would only have to go up by 5% to 5.5% a year in order for investors hit the maximum return.

Less leverage

Despite the attractive terms, Doucette said he would probably look to “reconstruct” the notes with the issuer. His reasoning was pricing as he tends to sell his structured notes on the secondary market before they mature.

“As I look at it, I don’t see it as an 18-month note. I would probably want to sell it I don’t know...maybe a year from now. We typically don’t hold notes until the end. But then with the leverage, I may not get the price that I want,” he said.

He offered an example, assuming no cap to simplify his point.

The Russell 2000 index would have gained 10% in a year. The notes “should be worth” 20% with the two-time leverage, “in theory,” he said. But the embedded options in a structured note are “not fully valued until they expire,” he explained.

Secondary pricing

“The value of the notes is not going to be two times leverage because the index went up. The value of the option on that index is worth more because you’re closer to maturity,” he said.

As a result, the leverage multiple would be lower if the note was sold prior to maturity.

“The value of the note mid-term would be more like 1.5 times instead of two-times. And if the market pulls back, I’m levered down as well,” he said.

If he was to close his trade prior to maturity, Doucette said he would face the risk of having to sell at a discount. Secondary prices tend to be lower than the original issue price. But Doucette would work on reducing the gap. To do that, he would renegotiate the terms with the issuer prior to purchasing the notes.

“I would reduce the leverage and increase the buffer so I can hold that note if the market is up without the worry of being levered down if the market goes down,” he said.

No one would “force” him to sell his note early, he said. But if the market is up, the risk of a downturn increases especially at today’s market valuation levels, he said.

“I would be willing to reduce leverage so that I can get a bigger buffer and perhaps increase the cap a little bit too or a combination of both...That way, I wouldn’t be forced to sell my notes at a discount value if the market is up,” he said.

Too short

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he was concerned about the timing and the length of the trade.

The Russell 2000 index is trading not far from its 52-week high.

“In general, I like the asset class. But I like it more over a longer tenor,” he said.

“In the shorter term we’re going to see some headwinds, which would bring to question whether the buffer would be sufficient.”

Part of the risk was due to the volatility of the Russell 2000 index, the benchmark for the U.S. small-cap stock market versus the large-cap segment of the U.S. equity market, which is tracked by the S&P 500 index.

“If the asset class has a correction, having a 10% buffer would reduce some of the losses but if we see a more severe downturn, small-caps historically drop more than the overall market.”

“My concern about the notes is the short tenor. The asset class should perform well over the next few years.

But right now, with a P/E of 19, you’re budgeting a lot more risk to get less return. Valuations are quite high and so is the risk. With a 10% buffer, I’m not sure you’re getting enough protection,” he said.

J.P. Morgan Securities LLC is the agent.

The notes will price on June 6 and settle on June 9.

The Cusip number is 46646EDZ2.

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