JPMorgan’s $1.15 million notes on S&P, Stoxx: Advisers like the terms, not the worst-of

By Emma Trincal

New York, Feb. 12 – JPMorgan Chase Financial Co. LLC’s $1.15 million of 0% notes due Nov. 6, 2025 linked to the performance of the S&P 500 index and the Euro Stoxx 50 index offered an attractive structure, advisers said. But the use of a worst-of in a growth note was much less appealing, they noted.

If the final level of each index is greater than or equal to its initial index level, the payout at maturity will be par plus 1.4 times the return of the least performing index, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will have exposure to the first 5% of the losses of the laggard index.

Not the right mix

“I like the 95% downside protection and the leverage,” said Kirk Chisholm, wealth manager and principal at Innovative Advisory Group.

“It’s also nice not to have a cap.

“I just don’t like worst-of. They’re never easy to sell. Who wants the worst of two indices?”

The two underliers were also “unappealing,” he added.

“The S&P is the most expensive. Its valuation is high. It’s going to drop at some point. If the U.S. market is down, Europe won’t be doing well either. Both benchmarks would generate poor returns,” he said.

If the Euro Stoxx turned out to be the worst-performing underlier, the outcome would also be negative.

“The Euro Stoxx has had a lackluster performance for a very long time. If it’s the worst-of, you won’t be doing very well,” he said.

Good structure

“I like the construct of the notes. Having uncapped leverage with 95% of your investment protected is appealing.”

But Chisholm, who uses options in his practice, said he could achieve similar terms and hedge without a note.

“You can do it on your own. I do these types of payouts on my own with call options,” he said.

He explained how.

“You simply buy calls and put the rest in Treasuries. Your risk is the call premium,” he said.

The cost of the premium was the equivalent of the maximum risk of 5% of principal incurred by the noteholders.

“It’s not that complicated. The worst-of is totally unnecessary,” he said.

On the plus side

Steven Foldes, founder and wealth manager at Evensky & Katz / Foldes Financial Wealth Management, said he also liked the structure.

“It’s a very interesting note,” he said.

“JPMorgan’s credit is excellent, perhaps the best among the big U.S. banks.

“Having a 95% principal protection is attractive for a short note. For longer dated note, we don’t think you need that much protection, but you certainly do over the short term.”

Fantom income

But the 95% downside protection came with a negative tax consequence for this adviser.

The note is considered to be a principal-protected note or PPN even though the principal is not protected at 100% but at 95%. Those structures are built combining a zero-coupon bond for the protection and call options for the upside participation.

Buyers of such principal-protected notes are likely to be subject to ordinary income taxes each year even though they do not receive any interest during the life of the notes, according to the prospectus. The taxable annual income is calculated using a “comparable yield” method, which is determined by the issuer.

“Typically, we want investments that offer long term capital gains. The idea of being subject to ordinary income taxes and having to pay taxes on a fantom income is not attractive to us at all,” he said.

“It may not be a non-starter but it’s definitely a big negative.”

The term “fantom” income refers to an income that has not yet been paid but is still taxable.

Performance gaps

For Foldes, the biggest drawback was the worst-of.

“We don’t like the idea of a worst of. If we have to use one, we need the correlation between the indices to be very high,” he said.

“We don’t want to see one index moving up and the other moving way down. It hurts our clients.”

Directions of price moves but also gaps in performance were both important risk factors, he explained.

“The difference in performance between the S&P 500 and the Euro Stoxx is pretty substantial. One did very well, the other, not so well,” he said.

“The 1.4 times leverage may not make up for the potential differential.

“That becomes a non-starter for us.”

This issue of dispersion in returns was also noticeable with domestic indexes, he noted, comparing the performance of the Russell 2000 index with that of the S&P 500 index, up last year 15% and 24%, respectively.

“So even if it’s nice to have 1.4x uncapped leverage and the downside protection, you do have this issue of being exposed to the lower performing index without mentioning this ordinary income tax burden,” he said.

Modifications

Foldes said he would reconstruct the notes with the objective of modifying the tax treatment and eliminating the worst-of.

“I would do the note differently,” he said.

“First, I would get rid of the principal protection and put some level of buffer so I can get a more favorable tax treatment. Moving from ordinary income to long-term capital gains would solve the tax problem.

For his second objective – getting rid of the worst-of and replacing it with a single underlier – Foldes said he would keep the uncapped leverage.

“I don’t like caps,” he said.

“I may try to reprice it on a single underlying with a 10% to 15% buffer and maybe for a longer term, 30 months or three years to see what kind of leverage I could get.”

In conclusion, Foldes said that the worst-of was not an option for him.

“When you want to invest for growth, why would you buy a worst-of? You’re taking a big risk that one of the areas would outperform the other significantly.

“No matter how attractive the terms are, it’s not a risk we’re willing to take,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes settled on Feb. 6.

The Cusip number is 48134T4G6.

The fee is 0.9%.

© 2015 Prospect News.
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