JPMorgan’s contingent interest autocalls on three indexes aimed at more defensive investors

By Emma Trincal

New York, Aug. 9 – JPMorgan Chase Financial Co. LLC’s autocallable contingent interest notes due Aug. 11, 2022 linked to the least performing of the Russell 2000 index, the S&P 500 index and the Nasdaq-100 index may find some resistance among investors given the worst-of payout on more than two underlying and the amount of contingent income, said Suzi Hampson, head of research at Future Value Consultants.

“The coupon feels quite low especially on three indices,” she said.

“But the note is more defensive than it seems at first glance.”

Each quarter, the notes will pay a contingent coupon if each index closes at or above its trigger value, 69% of its initial level, on the review date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission. The contingent coupon rate is expected to be at least 6% per year and will be set at pricing.

The notes will be automatically called at par plus the contingent coupon if each index closes at or above its initial level on any quarterly review date after one year.

If the notes have not been called, the payout at maturity will be par unless any index finishes below its trigger value, in which case investors will lose 1% for every 1% that the least-performing index finishes below its initial level.

Barriers

Hampson reviewed some of the features that may lower the risk.

“With a barrier level down at 69% you’re quite likely to receive your coupon. One of the three indices would have to drop more than 31%, and that’s a lot,” she said.

The same applied at maturity: investors would only lose money if the notes are not called and if the worst-performer finished below the same threshold.

“The coupon is weak for a reason. It has to reflect the level of risk you’re taking.”

Correlations

Another factor limiting both coupon risk and market risk was the correlation between the three indexes and also the nature of the underliers.

“These are all U.S. equity indices. Sometimes you see two underlying in different regions or markets or two stocks in negatively correlated sectors,” she said.

Correlation plays a key role in assessing the risk level, not just the number of underlying assets, she said.

Future Value Consultants produces stress-testing reports on structured notes.

The correlation between the Nasdaq and the Russell 2000 is 88.42%, according to the report for this product. Between the Russell and the S&P 500, it is 92.96% and it rises to 95.74% for the relationship between the Nasdaq and the S&P 500.

A perfect correlation would be at 100%.

Portfolio monitoring

One downside of having three underliers is that it makes it more difficult to monitor risk, especially for retail investors, she noted. The same holds true for worst-of deals in general but get to be more of a challenge with three assets.

“Volatility is hard to exactly pin down, and correlation is difficult to model. In our simulation, both factors are intertwined,” she said.

Monthly coupons

The structure offers other benefits, especially for income seekers.

One of them is the payment of the coupon on a monthly basis, rather than quarterly as it is often the case.

“Getting paid monthly is an advantage. The more regular the coupon payments, the better for the investor,” she said.

“It’s another reason why you don’t get a very high rate of return.”

One-year no call

Another advantage also contributing to a lower coupon rate is the one-year call protection.

“Investors will appreciate that, especially on a three-year. If you get called on the first observation, at least, you’ll get the full annual rate of return,” she said.

One of the reasons some income-seeking investors may not be “sold” on autocallables is reinvestment risk, which can be incurred as early as three months if the call is observed quarterly and can be triggered right away, she added.

“Being able to get a full year worth of income is more expensive to price. It will also contribute to decrease the coupon,” she said.

Putting it all together

“The notes, despite the low coupon, are more appealing than they immediately appear to be.”

That’s because the chances of earning the full coupon rate, at least on the first year, are substantial given this series of features. She summarized them: the reasonably low coupon barrier, the fact that the underliers are indexes and not individual stocks, the high correlation between them, the monthly payment of the income and the one one-year call protection, she said.

“Let’s not forget the autocall feature itself. Once you kick out, you get your entire principal back and you are no longer exposed to market risk and credit risk,” she said.

Product specific tests

The simulation model for this product confirmed Hampson’s observations. Each report contains 29 different tests or tables. Hampson began her analysis with one of them called “product specific tests.” The tests display the probabilities of outcomes, which depend on the product type.

For this autocallable contingent coupon, the specific outcomes include: probabilities of getting a coupon for each of the 36 payment dates; probabilities of a call for each of the eight observation; and probabilities of a barrier breach.

Each report also includes five distribution assumptions, which represent five market scenarios, all of which are based on volatility and different growth rate assumptions for each of the underlying.

One of them, the neutral scenario, is the basis of the simulation in all reports, reflecting standard option pricing. The others are bull, bear, less volatile and more volatile.

Call at point 1

The notes will be called on the first observation date (call at point 1) 44.45% of the time, revealed the table.

“It’s generally higher ... around 50% ... with a single index depending on the forward rate of the underlying,” she said.

“The odds decrease with three underlying, however not by much, at least in the neutral scenario.”

The call at point 1 event indeed sees its probability vary significantly based on the type of market.

In the bear market for instance, investors will be called on the first observation date 32.46% of the time while the probability will rise to 57.36% in the bull scenario.

“Call at point 1 is quite affected by the market environment you’re in,” she said.

“Also, the longer you go, the lower the probabilities of kicking out.”

While the call at point 2 has a 7.03% chance of happening, the probabilities decrease to 4.82% at point 3 and to 1.28% at point 8.

Coupon distribution

The coupon payment distribution reflects in part the high probability of calling at point 1, she noted. Investors will receive 12 monthly coupons 45.02% of the time, which is the greatest probability of coupon payments overall.

“That’s where the kickout will be. That’s where the odds of getting paid are the greatest,” she said pointing to the one-year no-call feature.

The difference between the 44.45% probability of a call on the 12th month and the 45.02% chances of getting all 12 coupons however small it may be (0.57%) can still be explained: it would coincide with the very unlikely situation in which the index, 12 times in a row, would close above 69% yet below initial price.

“As you can see, it’s highly unlikely to get all your 12 payments without kicking out,” she said.

No middle-ground

Switching over to another table, called “capital performance tests,” Hampson looked at the three table outcomes: return more than capital; return exactly capital; and return less than capital.

“With this note, the probability for ‘return exactly capital’ is zero,” she said.

“You’ll either get your capital plus income or you will lose some of your capital.”

This is simply because it is the same 69% barrier that will determine whether the coupon is paid or not and whether principal will be fully repaid or not.

“If it was a growth product, it would be a very different thing. You would get ‘exactly capital’ each time the index finishes between the protection threshold and the initial price,” she said.

“Obviously, it would not be a zero probability.”

Market-dependent

The two remaining outcomes of the table (loss or gain-plus-capital) also see their respective probabilities highly conditioned by the market assumptions.

For instance, the barrier will be breached 31.9% of the time in the bear scenario but only 7.57% in the bull market, according to this table.

Investors will get their money back and some income 92.43% of the time in the bull market and 68.1% in the bear.

“It’s quite sensitive to the direction of the market,” she said.

Back-testing

Back-testing analysis seen in the next table, however, showed how well the product performed over past periods on the basis of three-year rolling periods.

The notes returned more than capital 100% of the time in the last five years. Over the past 10 years, it was 99.68% of the time.

“Those results are quite positive,” she said.

“We’re dealing with an income product that offers a number of risk mitigation factors.

“It’s for investors who want equity exposure and who are comfortable with the relationship between the three indices. We know they are highly correlated.

“The 6% coupon at first glance is not very impressive. On the other hand, the probability of getting that coupon for some period of time is quite decent.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will settle on Tuesday.

The Cusip number is 48132CY98.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.