JPMorgan’s enhanced notes tied to S&P, Russell offer step-up-like return with leverage

By Emma Trincal

New York, Aug. 17 – JPMorgan Chase Financial Co. LLC’s 0% uncapped buffered return enhanced notes due Sept. 3, 2022 linked to the lesser performing of the S&P 500 index and the Russell 2000 index offer benefits over the traditional “market-linked step-up” or “jump” securities, which it resembles in conception.

The difference is the inclusion of a second underlier, creating a worst-of payout that allows the pricing of some beneficial features, sources said.

If each index finishes above its 128% upside threshold, the payout at maturity will be par plus 1.2 times the return of the worse performing over the contingent minimum return of 28%, according to a 424B2 filing with the Securities and Exchange Commission.

If each index gains by up to the upside threshold, the payout will be par plus 28%.

Investors will receive par if either index falls but by no more than 30% and will be exposed to any losses of the worse performing index beyond 30%.

Step-up 2:0

The structure offers a revision of the now classic “market-linked step-up” brand made popular by Merrill Lynch, according to data compiled by Prospect News. Other firms offer the same structure.

In this latest version though, the underlier is not a single asset but two indexes giving way to a worst-of payout. For this additional risk, investors enjoy some leverage above the digital threshold instead of the typical delta one exposure.

In addition the product pays a large buffer. In both versions, the upside above the digital or “step-up level” is uncapped.

Correlation

Steve Doucette, financial adviser at Proctor Financial, said that the structure of the notes was appealing but that the length of the product was more problematic.

“I like the parameters of the notes. You really outperform the market no matter what,” he said.

“It’s the worst-of the two indices so you’re subject to a little risk. But theoretically you should outperform that particular index.

“The key is if they go more or less in the same direction.”

As explained in the prospectus, investors have a risk exposure to each index, not just one. If one of the two declines in price, a positive performance by the other may not offset the losses the way it may in a basket.

This is why examining the correlation between the two indexes matters in a worst-of, he said.

When the correlation is high, investors are exposed to less risk, he said.

In this case the correlation coefficient between the two indexes is 0.8.

If the correlation between the two benchmarks appeared strong, history showed patterns of divergence.

“It’s hard to guess which one it’s going to be. It really depends on what market cycle we’ll be in five years from now,” he said.

In an “up market,” the small-cap sector of the market tends to outperform while it is the reverse when the market turns negative, he explained.

Long bull

“That’s if history repeats itself. The hard part with this one is the timeframe...this uncertainty thing. Look five years out...It’s hard to make a prediction. It’s already hard to have a view for the next two or three years although you get better probabilities,” he said.

Merrill Lynch’s market-linked step-up notes are shorter in duration.

Their average tenor is 3.33 years, according to data compiled by Prospect News covering 100 of this agent’s “market-linked step-up” notes priced this year through the beginning of this month. Most of those are autocallable.

On the other hand, they do not come with buffers. And while those notes can offer barriers, the majority of them has no downside protection.

The pricing benefit of the worst-of is the buffer in this product, he said.

Yet he was not certain whether 30% would be enough.

“Here we are in an eight-and-a-half year bull market, the second longest bull market in history,” he said.

“What are the odds of losing more than 30%? We know that the odds of a bear adjustment are pretty high.

“Where would I want to put most of my optionality in a structured note? Which side of the scale do you put that on?”

Shortening the term to a one-year to three-year note with more downside protection and less leverage would be his preference.

“Obviously the way they did it doesn’t really work for me,” he said.

“The main issue here is timing. No one knows what’s going to happen in five years. So I would go for the bigger buffer.”

Simplicity

Matt Medeiros, president and chief executive of the Institute for Wealth Management, pointed first to the complexity of the structure.

“The challenge with these is to explain the product. You should be able to explain the concept to a client in less than two minutes. Not only it’s a struggle to explain it but it’s also hard for you to determine your expectations. It’s just more triggers and mechanisms you have to track to understand what your return should be,” he said.

Medeiros said he was comfortable with the two underlying indexes.

“If you’re trying to get exposure to domestic equities, these two are good benchmarks,” he said.

S&P exposure

The correlation did not pose much risk on the downside, he said. If anything, it was on the upside that one index would be the most likely to behave differently from the other.

“They’re highly correlated on the downside. On the upside, because of the current valuations of the S&P, I would expect the Russell to outperform.

“That’s the way I would evaluate this. In other words, if I had to guess, I would expect the worst performing index to be the S&P.”

The size of the buffer was very attractive.

“It gives you a good opportunity to get some positive return without excessive risk because the buffer is sufficient for this timeframe,” he said.

Dividend

The only question for investors was to feel comfortable giving up dividends.

“You have to set the total return expectations for the index and then see at what point does the leverage kick in.

“I would prefer to get the leverage, above the 28%, so that I will be compensated for the loss of dividends,” he said.

In conclusion, Medeiros said the downside protection was what made the product the most appealing.

“I really like the buffer. But from my perspective I would look at a single index and design something that is more in line with my market expectations. It is too challenging to manage your risk and return expectations when you’re dealing with the complications of having two different underliers.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price on Aug. 31.

The Cusip number is 46647M2D4.

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