JPMorgan’s yield notes on S&P 500, Russell 2000 to pay fixed rate over short tenor

By Emma Trincal

New York, April 3 – JPMorgan Chase Financial Co. LLC’s 8% yield notes due July 9, 2021 linked to the lesser performing of the S&P 500 index and the Russell 2000 index are reverse convertible notes, a structure, which has become less common than autocallable contingent coupon notes as pricing a fixed coupon can be expensive, said Tim Mortimer, managing director of Future Value Consultants.

Interest is payable monthly, with the exact coupon to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par unless either index closes below its 75% trigger level on any day during the life of the notes and either index finishes below its initial level, in which case investors will lose 1% for each 1% decline of the worst performing index from its initial level.

Guaranteed coupon

Mortimer compared the notes with the more common autocallable contingent coupon notes.

“This is a fixed coupon,” he said.

“Phoenix autocallables are more popular now. The yield you can get out of it is higher everything being equal.”

The term Phoenix autocallable refers to notes that pay a contingent coupon if the underlying is above a coupon barrier on an observation date. Such barrier is usually below the call trigger, which is itself set at the initial level.

Short and sweet

Unlike growth products, which may offer better terms with an extended maturity, reverse convertibles tend to benefit from shorter holding periods. Another characteristic of reverse convertibles aside from paying a fixed rate is the absence of a call feature.

“For a reverse convertible, the shorter the period, the easier it is to pay a higher rate,” he said.

“It would be more expensive to pay a rate over a long time obviously.”

Nonlinearity

The main source of premium is the chance of losing money, he added.

But the relationship between risk and yield is not linear, he explained.

“The longer the term, the higher the risk, but the risk does not go up as fast as the rate. So, it’s easier to price a reverse convertible over a shorter period,” he said.

He gave a simplified example.

If a note pays 8% per annum, the 32% return after four years will be twice higher than the 16% return after two years.

“But the extra risk on a four-year is not double the risk on a two-year while the interest rate is double.

“It’s much cheaper to price a fixed coupon short term,” he said.

Contingency premium

Other factors explain why reverse convertibles can be expensive in relation to an autocallable contingent coupon product.

“The reverse convertible pays the income irrespective of what the index does whereas the payment is subject to certain barrier conditions with the Phoenix autocall. Your coupon is at risk.

“In addition, since the Phoenix are autocallables they often finish much earlier,” he said.

Any day observation

The issuer used the American barrier to slightly enhance the coupon, he added.

American barriers named after options carrying the same name are observed on any day during the life of the notes as opposed to the traditional “European” barrier, which is monitored at maturity only.

Mortimer noted that American barriers are “quite rare” with Phoenix autocalls.

“They’ve used one here in order to keep the yield high enough to help them compete with the autocall,” he said.

“It’s normal for clients to compare yields across different products even though a Phoenix autocall and a reverse convertible have very different risk profiles.

“So, they increase the income by adding a little bit more risk.

“But if the product is only 1¼ year, that risk isn’t much.”

The incremental risk may encourage some investors to accept the American barrier even though in essence such barrier remains always riskier than its European counterpart because the number of opportunities to breach is greater.

But investors seeking to stretch the yield may take the calculated risk.

American trade-off

“With the American barrier, the only way you can be in a worst situation than with a European barrier is if you go through the barrier during the life and finish negative but above the barrier, or between 75 and 100,” he said.

“But with a 1¼ year, there isn’t that much time for this to happen,” he said.

His example emphasized the added risk that comes with the American barrier only, not the overall risk.

Of course, investors in the American barrier note would lose as well below the 75 level but so would the holders of a note featuring a European barrier of the same level and the losses would be identical in both cases.

“So, you probably don’t get a lot of extra yield, but you don’t take a lot of extra risk either.

“Some investors may be happy to go with an American barrier for a slightly better yield because they’re not too concerned about the extra risk over the short term,” he said.

Correlation

The payout is based on a worst of two indices, another way to generate extra premium compared to a single asset underlier, he said.

The current bear market adds the important element of elevated volatility. Investors will have to have confidence in their own directional view over the short term.

“Both indices are striking quite low. Of course, they could go much lower, no one can tell,” he said.

“But a 25% barrier from here... it’s an awful way down from their high. Most people would hope that 25% would be enough. How much bad news can you get in the next year?”

The dispersion risk is somewhat reduced by the correlation between the two U.S. equity benchmarks.

The correlation between the S&P 500 and the Russell 2000 is 95.73%, according to Future Value Consultants.

“The return is linked to two highly correlated indices, which is fine especially starting from those low levels. It gives some margin of safety for those who need to use a reasonable amount of caution,” he said.

“Everything is always possible, and you could have another disaster. But it’s quite unlikely.”

Stress testing

Future Value Consultants runs stress testing reports on structured notes for its clients. Each report has 29 tables or tests, which determine the probability of outcomes associated with the specifics of the structure.

One of the reports, the scorecard, shows outcome names, probability of occurrence, average return and average duration. Those probabilities are calculated via a Monte Carlo simulation under the neutral scenario, which is a base-case scenario reflecting standard pricing based on the risk-free rate, dividends and volatility of the underlying.

Scorecard

The scorecard for this note shows a 58.79% chance of full capital return.

On an annual basis, this outcome would translate into 100 plus 8% a year, or 108% of total return.

Because the note has a 15-month duration, the average payoff would be 110%.

The second outcome – “capital loss but total return at or above capital” – reflects a situation in which the loss of principal is compensated by the coupon, so that investors do not get less than 100 at maturity.

“That’s when the index finishes between 92 and 100,” he said.

This outcome is rare and has a probability of 5.19% only.

His example was hypothetical and based on a one-year maturity to simplify the scenario.

For instance, if the worst-performing index closes at 95%, investors may lose 5% but with the coupon, they end up with a 103% payout.

The third outcome is a total return loss. In this case, the coupon is not enough to offset the loss of principal. The index has dropped below 92%.

The scorecard points to a 36.02% probability associated with this negative scenario under the neutral assumption.

Back-testing

Future Value Consultants in addition to its simulation provides back-testing analysis in each of its reports. They can be customized for the past five, 10 or 15 years.

“Back-testing shows much better results,” he said regarding the total return loss outcome.

The analysis points to an 8.74% frequency for this outcome in the past 15 year, but only 0.6% in the last 10 years and 1.03% in the past five.

The impact of the 2008 financial crisis can be felt over the 15-year lookback period, which explains the more negative result.

Market scenarios

The neutral scenario is not the only distribution assumption used in the simulation.

The model runs four other assumption sets, representing four market scenarios which are based on volatility as well as different growth rate assumptions. Those are bull, bear, less volatile and more volatile.

Probabilities and average payoff results for those four scenarios can be seen in another table called “capital performance tests.”

Under the bull scenario, the “return less than capital” outcome continues to show a high probability of 29.59%. It is naturally higher under the bear assumption with a 43.49% probability.

“Both our bull and bear are based on different growth rates above or below the neutral,” he said.

In its methodology, Future Value Consultants adopts conservative growth rates for its market assumptions to avoid extreme scenarios and to facilitate comparisons across products.

Maturity, volatility

The tenor also plays a role in these results.

“On a one-year and a quarter, those growth rates don’t have much of an impact,” he said.

“With a short maturity, it’s more about the existence of a market shock. The growth rate is not going to help you a lot.

Which leads to volatility.

“The recent market moves have pushed volatility to very high levels. Our model assumes that it’s likely to persist at those levels,” he said.

“Had we run this test one or two months ago, the risk of losses would have been much lower. If volatility returns to normal levels, you’ll see the probability of losses decrease significantly.”

Mortimer said the notes are designed for relatively optimistic investors.

“This is for people looking for income who don’t expect that a shock of this magnitude is going to be extended for a long period of time,” he said.

“If you believe we’re heading for a flat or moderately down market, then it makes sense.

“But if you anticipate further losses in the market, then it’s not the structure to go for.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48132KLM5) will settle on Wednesday.

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