JPMorgan’s $12.05 million contingent interest, leveraged notes linked to S&P 500 offer novelty

By Emma Trincal

New York, Dec. 7 – JPMorgan Chase Financial Co. LLC’s $12.05 million of contingent interest and contingent leveraged notes due Jan. 7, 2022 linked to the S&P 500 index show a relatively new structure, according to data compiled by Prospect News.

The product features a contingent coupon payable under conditions that sources deemed restrictive, as it is based on a thin American barrier – the term “American” designating a barrier that can be observed at any time.

Investors will get either income or growth at maturity based on a novel leverage formula that applies not only to the index return but also to the buffer amount, which is what constitutes the most original aspect of the structure. The issuer does not provide for any call or autocall feature.

A different one

The notes pay a monthly contingent coupon at the rate of 6.75% per year unless a trigger event – the index closes below the trigger value, 90% of the initial index level, on any trading day – occurs, in which case no coupon will be paid that month or any subsequent month, according to a 424B2 filing with the Securities and Exchange Commission.

If a trigger event has not occurred, the payout at maturity will be par plus the final coupon.

If a trigger event has occurred, the payout will be par plus 1.11111 times the sum of the index return and 10%. This formula will result in a payout of less than par if the final index level is less than the trigger value.

“I haven’t seen it before,” said a market participant.

Recently priced

This structure is relatively rare indeed.

Royal Bank of Canada in mid-October priced a nearly similar deal. It was $20.21 million of contingent coupon buffer enhanced return notes due Oct. 19, 2021 linked to the S&P 500. The buffer was 15% instead of 10%. The barrier was also observed on any day. The contingent coupon was 4.65% per year. Similarly to the JPMorgan notes, all coupon payments stopped upon the barrier breach (knock-in) event. The payout formula at maturity in the event of a knock-in was the same. The difference was the buffer amount of 15% and a leverage factor of 1.1765.

Coupon at risk

“My first instinct is that six years is really too long,” the market participant said about the recently priced JPMorgan notes.

Given that it only take a 10% index decline on any day for the structure to annihilate all future coupon payments, this source was skeptical about the income quality of the product.

“You can expect to hold six or seven months with the coupon. After that, the model assumes that it stops.

“Since there is no capital guarantee, it’s very much like an equity-linked note based on the return of the S&P, making this product inappropriate for the risk-averse investor,” he said.

Because investors are unlikely to receive the coupon payments for a long period of time, this market participant said the coupon enhances the “optics” of the deal but may not be of great use.

Six years

“It looks good. On an annual basis, 6.75% looks very attractive. But I wouldn’t expect the coupon to last,” he said.

The contingency, though, is one of the few ways issuers can successfully boost yields in the current interest rate environment, he added.

“If you had a reverse convertible with exactly the same underlying, the same terms, the same maturity but with a fixed coupon, you would probably get 1% or less.”

This market participant said that the notes are more of a growth than an income instrument given the barrier.

“The coupon is highly at risk,” he said.

“I don’t like it because of the long term. We just don’t strike six-year products.”

Make it callable

Instead, he described a product his firm recently offered, which showed similarities with the JPMorgan notes.

It was a five-year product with full principal protection. The 0.75% coupon was guaranteed. The notes, after one year, were callable at the discretion of the issuer. If the issuer called the notes, he had to pay investors a 6% per year cumulative coupon. If at the end of the term the notes had not been called, investors were exposed to 100% of the upside with no cap.

In both cases a particular event – the call with the five-year example or the breach of the barrier with JPMorgan’s notes – interrupted the normal pattern of income distribution.

Upon the call, as described by the market participant, investors see their coupon upsized eight-fold. Upon a barrier breach with the JPMorgan notes, noteholders have access to a new form of return enhancement at maturity.

This market participant said that most investors would not be comfortable with a long tenor absent a call or autocallable feature when the likelihood of a trigger event is so high.

“Unless you are super bullish for the next six years, I don’t really see the point,” he said.

“If the market is really up, you’re probably better off selling it prior to maturity. Say you put it back to the issuer after three year if the market really had a good run and you can get a decent bid.”

Moving parts

The complexity of the structure was a concern for another source.

“It’s a headache. How many retail clients can really understand this? Once you get into the third moving piece, you’ve just lost them,” this industry source said.

“The more moving pieces I see, the more it is difficult to know what the bank’s margins are. We just don’t know the value of these options.”

This source added that he was not comfortable with the product as it did not fit into a clear category.

“The coupon is almost a teaser. It’s more of a growth product than an income product. The income is dicey to say the least.”

Retail investors buy notes based on two conditions, he said: their own “instinct” and the ability of the financial adviser to persuade them.

“A lot of advisers are great people, don’t get me wrong. But this is just too complex for the little guy.”

Should the notes be designed for institutional investors, his opinion would be different.

“If it’s not for retail clients, I would change my tune. Leave institutions to make their own mind."

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 46646QDR30) priced on Dec. 2.

There was no fee.

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