JPMorgan Chase's knock-out buffered notes linked to S&P 500 compete with pure long-only play

By Emma Trincal

New York, Jan. 27 - JPMorgan Chase & Co.'s 0% knock-out buffered notes due Feb. 9, 2017 linked to the S&P 500 index offer downside protection and exposure to the S&P 500 without investors having to sacrifice much in potential gains, sources said.

As a result, the notes may be a good or even better alternative to a long-only investment as they add the downside protection feature that would be lacking in a long position, they noted.

A knock-out event occurs if the index falls by more than the knock-out buffer during the life of the notes. The knock-out buffer will be at least 38.25% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index finishes above its initial level, the payout at maturity will be par plus the gain.

If the index finishes below its initial level but a knock-out event does not occur, the payout will be par.

If the index finishes below its initial level and a knock-out event does occur, investors will be fully exposed to the index decline.

Good pricing

"You pay a fairly modest price for a pretty good degree of protection," said Jonathan Tiemann, founder and president of Tiemann Investment Advisors, LLC.

"You get the JPMorgan credit, which isn't bad, [and] the lack of liquidity, which is usually what happens with these types of structured products.

"If you're really interested in investing in the S&P 500 for three years, it might be a good play."

The only returns investors will not be receiving will be the dividend distributions, which are not offered to the noteholders. The opportunity cost represents a 1.82% annualized yield over three years, he noted.

American option

"You're sacrificing the dividends for the sake of the protection," he said.

"The protection has a limit. It's interesting how advantageously they priced this product and how they set that limit that far. The buffer size is quite big even if we know that the protection can end any day. It's not just a final barrier, but still. I would have expected to see less protection than 38.25% even with an American option."

American-style options or barriers can be exercised or triggered any time during the life of a contract or note. In contrast, a European option, or the traditional barrier observed at maturity, can only be observed or triggered when a contract expires or when the note matures.

"If you want to have long-term exposure to the S&P 500 and want some protection on the downside, this note can reduce your risk, and you're not losing anything on the upside except for the yield," he said.

"It would not be my style of investing because I wouldn't want to be locked in for three years. But I can see that the pricing on this deal is quite attractive."

Long the index

Carl Kunhardt, wealth adviser at Quest Capital Management, said that the appeal of the notes lies in the simplicity of the structure. Investors in the notes are not "worse off" than equity investors, which is not always the case in structured investments, he said.

"I like it because it's straightforward. If you trigger the knock-out, you're long the position. They don't take anything away other than the dividends," he said.

"You're really not worse off than being long the position without the dividend.

"It's very easy to explain to a client how it works.

"I don't particularly like the triggering any date. It feels safer when your trigger is at maturity instead. And yet, you may not be any safer. It really depends on the amount of protection you get. This 38% buffer is pretty substantial."

Multiple uses

Because of the size of the protection and the fact that the upside is not capped, Kunhardt said that the notes could have a place in diverse portions of his portfolio, including those with a moderate risk profile.

"I would not use it in a conservative portfolio, but I would look at it for the more aggressive equity bucket, which can withstand equity volatility. You're not adding anything negative in the portfolio when you put in the position," he said.

"I have to say, I would even selectively include this in some of my moderate portfolios.

"We have three moderate portfolios. The one in the middle is the balanced portfolio with a 40%-60% mix, 40% being cash and fixed income and 60% equity. We've changed that mix actually to 35%-65%. On the more conservative end, we have the 50%-50% conservative balanced and on the riskier side, the 30%-70% balanced growth.

"On the balanced growth, I would not hesitate using this.

"With the balanced portfolio, which is conservative, in theory you would include anything that would put you at risk of losing 20% or more. But the 20% limit is for the entire model. We're only talking about a position in the portfolio. So I may put it in this bucket as well.

"There would be room in my moderate portfolios for this. Would I put it in the balanced growth? Certainly. In the balanced portfolio? Probably. In the conservative balanced? Maybe.

"I find this deal very interesting. There are no games, no bells and whistles. It's a very fundamental structured note."

J.P. Morgan Securities LLC is the underwriter.

The notes will price on Feb. 6 and settle on Feb. 11.

The Cusip number is 48126NZ83.

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