JPMorgan’s notes linked to two indexes offer unusual example of worst-of with leverage, no cap

By Emma Trincal

New York, Aug. 16 – JPMorgan Chase Financial Co. LLC’s 0% uncapped contingent buffered return enhanced notes due Aug. 31, 2021 linked to the lesser performing of the S&P 500 index and the Russell 2000 index offer investors leverage with no cap on the upside, two features not often seen with a so-called worst-of payout.

If each index finishes at or above its initial level, the payout at maturity will be par plus at least 1.75 times the return of the worse-performing index. Investors will receive par if the worse-performing index falls by up to 50% and will be fully exposed to the losses of the worse-performing index if either index drops by more than 50%, according to a 424B2 filing with the Securities and Exchange Commission.

Worst-of payouts have been used a lot this year but mostly in income products, according to data compiled by Prospect News. The typical structure is linked to two or three indexes and offers a competitive contingent coupon when all underliers close at or above a coupon barrier at a specific time.

Worst-of structures are also widely found among digital notes.

When leverage is employed, which is uncommon, the upside is usually capped, according to the data.

Credit, correlation

Steven Foldes, vice-chairman at Evensky & Katz/Foldes Financial Wealth Management, said there are many features to like in the product. Unfortunately, a few things are missing.

“It’s an interesting note,” he said.

“JPMorgan is a very strong credit. That starts off in a positive way.”

JPMorgan Chase Financial is the issuing subsidiary of JPMorgan Chase & Co., which guarantees the notes.

The worst-of feature can add substantial risk when the underlying indexes have very low or negative correlation. But this is not the case with the S&P 500 and the Russell 2000, he said.

“While one is large cap and the other small cap, you’re not going to get killed. They have a high correlation,” he said.

The five-year correlation coefficient between the S&P 500 and the Russell 2000 is 0.89, according to Morningstar.

Worst-of structures tend to be riskier when the reference assets move in opposite directions, as it increases the chances of having a negative return.

Leverage, no cap

Foldes said he also likes the leverage factor.

“Having 1.75 times on the upside is very nice for something like this, and it’s uncapped,” he said.

Finally, having a 50% barrier on the downside is also “very attractive,” he said.

Five years

Yet Foldes would not consider investing in the notes.

“Despite these positives, a few things are negatives for us. We would have to renegotiate the terms to consider this investment,” he noted.

The first and most important “negative” is the tenor.

“It’s a challenge for us. We just don’t like tying up money for five years. We would prefer that it’d be shorter.”

Barrier

A second “negative” is the type of protection.

“While 50% on the downside is great, it’s not a real protection. If the worst index takes us down 51%, it’s a true loss as opposed to the absolute protection you can get with a buffer,” he said.

Foldes said he would rather have a smaller buffer than the 50% barrier.

“An absolute protection of 30% would be much preferable than this barrier,” he said.

Finally, the longer period increases the cost of not being entitled to receive dividends.

“You have to realize that you’re giving up about 10% on the basis of dividends,” he said.

“It overcomes for us the 1.75 leverage.”

Back to drawing board

Foldes said he would “renegotiate” the notes to obtain a shorter term and replace the barrier by a buffer.

“We may have to give up some of the leverage or some of the downside protection,” he said, referring to the percentage amount of protection.

However, this adviser said he would not give up the “uncapped upside,” as this part of the structure is one of the most compelling.

“It’s an attractive note overall. With some kind of fine-tuning, it would fit the special needs of our clients,” he said.

Bulls

Some may find the notes attractive as they are.

The uncapped upside along with the low contingent protection are suitable for bullish investors, a market participant said.

“If you have any positive outlook and a bullish view, that’s going to work for you,” this market participant said.

The observation of the barrier at maturity rather than anytime during the life of the notes is also a plus.

“It’s not an internal knock-out. If it knocked you out in the middle, that would be worse, but you’re not going to be down 50% five years from now or you would have World War III. I mean, if we’re down 50% in five years we would be in a lot of trouble. ... We would have more things to worry about.”

The risk of having one’s return tied to the worse-performing index is not a major drawback in his view.

“The S&P 500 and the Russell are not negatively correlated. It’s two domestic stock benchmarks. It’s not stocks and bonds or stocks and commodities. Stock indices are usually pretty correlated. So getting the worst return would not prevent me from doing the trade.”

The notes will price on Aug. 26 and settle on Aug. 31.

The Cusip number is 46646ESB9.

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