JPMorgan's leveraged buffered notes linked to S&P seen as risk-control tool during sell-off

By Emma Trincal

New York, April 18 - JPMorgan Chase & Co.'s 0% capped buffered enhanced participation equity notes due Aug. 6, 2014 linked to the S&P 500 index may offer investors a timely way to hedge their market exposure as the decline in stock prices is intensifying, a financial adviser said.

If the index return is positive, the payout of the notes at maturity will be par plus 1.2 times the index return, subject to a cap of 9% to 12% that will be set at pricing. Investors will receive par if the index declines by 10% or less and will lose 1.1111% for every 1% that the index declines beyond 10%, according to a 424B2 filing with the Securities and Exchange Commission.

Hedging

"These are pretty plain-vanilla notes. If you think there might be a pullback in the market, it may be a good idea to switch from a direct equity exposure to a leveraged buffered note. That way you can add basic protection," said Steve Doucette, financial adviser at Proctor Financial.

Separately, JPMorgan announced a similar product but linked to an equity benchmark of developed countries. JPMorgan's 0% capped buffered enhanced participation equity notes due July 23, 2014 linked to the MSCI EAFE index offer 1.4 times the index return on the upside subject to a cap of 8.5% to 11.5%. Investors will receive par if the index declines by 12.5% or less and will lose 1.1429% for every 1% that the index declines beyond 12.5%, according to a 424B2 filing with the SEC.

"Nobody is going to complain about a 10% annual return even if by some stretch of the imagination the market continues its bull run of the first quarter," Doucette said.

Commenting on the two different products, he said: "They're exactly the same notes, just a different exposure.

"When you're trying to decide which one to use, you just have to look at your portfolio and see if you want to hedge some of your S&P exposure or EAFE exposure. It might be both. If the market gets ugly, the correlation between those two indexes will be close. So it's just a matter of where it may fit in your portfolio."

The strong rally in equities has recently been interrupted amid disappointing U.S. economic data and worries around earnings. Concerns about a Chinese economic slowdown and the continued European crisis have also helped push stock prices down.

"I've kind of have been waiting for this for a while," Doucette said.

"I think now is a good time to temper the market with some downside protection. It's been such a momentum with everybody going from cash to equities. When everybody starts to chase the market, it's a good time to think about risk control. Those leveraged notes limit your upside, but they partially protect you from downside losses.

"The current pullback was overdue, and I think it's a good thing for the market."

Roll it

For investors who do not anticipate a sustained correction, the notes offer a chance to roll the risk over, he said.

"We've ourselves put some leveraged notes in place some time ago, and we've capped our return in order to hedge the downside," Doucette said.

"If you hit the buffer when the market retreats, as you get close to maturity the question becomes, Do we roll them over?

"When your returns have been levered up, the closer you get to maturity, the more you see your returns come down if the market retreats. By definition if you're levered up, you're coming down further than the market. As a response to that, we might reset the buffer and roll up the notes into new ones."

Still a bull

More bullish investors, however, feel that they're paying too high a price by sacrificing some of the upside in order to get a buffer.

"If you're bullish on the market, as I am, I'm not sure why you would be buying this," said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

"The market could continue to pull back a little bit, but we're optimistic. Therefore, I'm not sure that I'd want to be capped 10% on the S&P, which has already performed better than that for this year."

Before the sell-off, which began Friday, the S&P 500 was up nearly 11.5% for the year. Since then, however, sharp losses on Monday, Wednesday and Thursday have sent the benchmark 3% lower.

"We think the S&P is still trading at an attractive P/E," Medeiros said.

"Therefore, we don't see the need of limiting the upside even for a 10% buffer. In fact my preference would be no cap and more downside protection relative to the standard deviation of the S&P. It may not be something you can price, and in that case, I would just rather be long equity instead of buying the notes. That way I can get out if I need to."

Medeiros said that the recent S&P 500 losses were simply a timely correction.

"The market is rather spooked right now, but I think there are more reasons to be optimistic than pessimistic. The recent sell-off is a natural, relatively healthy pullback in the context of a market that has run up considerably in quite a short period of time.

"On the other side of the ledger, people are not seeking shelters, they're not chasing gold. It tells me that they're not worried that the sky is falling.

"The recent report of a slower economic growth in China frankly is causing some of the sell-off. But this is partly due to the fact that many analysts were too optimistic. They expected an 8% GDP for the first quarter, and we had 7.7%, which is still very strong.

"I can understand why you would use these notes as a hedge. But I think you're still paying too much in potential upside. I don't think the rally is over yet."

J.P. Morgan Securities LLC is the agent for both offerings, which it will sell to an unaffiliated dealer.

The notes linked to the S&P 500 (Cusip: 48126DX95) and those linked to the MSCI EAFE index (Cusip: 48126DX87) were expected to price April 18 and settle April 25.

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