JPMorgan’s digital equity notes tied to S&P 500 index can help smooth volatility out

By Emma Trincal

New York, Oct. 19 – JPMorgan Chase Financial Co. LLC’s 0% digital equity notes due Nov. 20, 2019 linked to the S&P 500 index are designed for investors who are seeking a fixed return and less risk than a direct long position in the market, said Suzi Hampson, head of research at Future Value Consultants.

As an investment the notes may offer a tool to reduce risk in a portfolio, she added.

“You get your payout even if the index is down, at least within the buffer range. This should appeal to moderately bullish investors who want to mitigate the risks associated with full participation in the index,” she said.

If the S&P 500 index finishes at or above 90% of its initial index level, the payout at maturity will be par plus a payout that is expected to fall between 8.16% and 9.58% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will lose 1.1111% for each 1% decline in the index beyond 10%.

Defensive play

“We call these products: ‘defense digitals’ in the U.K.,” she said referring to the threshold below par, which enables investors to gain from up to a 10% market decline.

“Obviously the digital limits your return. It’s not a bullish note. If you are bullish over the next 13 months, you probably need a growth product with participation in the upside,” she said.

Investors in the notes will outperform the S&P 500 if its return is anywhere above 90% of its initial level and below 8.87%.

She picked the digital payout as 8.87%, which is at the midpoint of the range.

“Obviously this is a narrow window. You’re not trying to chase returns here. You just want to limit the risk and maximize the chances of getting your fixed payout,” she said.

Alternative

The note was similar to an autocallable in that the payout is fixed. But unlike an autocallable, the duration of the investment was known and fixed. One similarity though is the relatively short tenor of the notes even if the duration of an autocallable product may be as short as three or six months if the option is exercised, she said.

“It’s a nice way to get a different type of return on a familiar index. On a 13-month deal, you’re not worried too much about being locked in for a long time,” she said.

The notes can also be seen as an alternative to an exchange-traded fund.

“It’s a different tradeoff, though. Both instruments give you exposure to the market. But with the ETF, your capital is at risk. On the other hand, your upside is unlimited. What you get with the notes is protection with a buffer as well as a greater chance to reach your target return because of the trigger set at 90.

Capital performance tests

Future Value Consultants runs stress-testing reports on structured notes. Hampson used some of the tables of the report she ran for this product to illustrate her points.

The Monte Carlo simulation uses market and implied data to run the tests, including risk-free rate, issuer credit spread, deposit rate, dividend yield and volatility as well as correlation matrix.

Hampson picked one of the 29 tables included in each report, called “capital performance tests.”

This table shows the probability of each of three outcomes – return more than capital, return exactly capital, return less than capital.

Probabilities

The probabilities are calculated based on a set of four market scenarios: neutral as well as bullish, bearish, less volatile, more volatile.

The neutral scenario reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying. Each market scenario uses a different set of growth and volatility for the underlying.

The capital performance tests table showed a high probability of getting the digital payout in all markets but primarily in the bull market with a probability of 86.24% and in the less volatile market with an 84.21% chance. In the neutral scenario, the odds of getting paid are less at 79.61%. Naturally the bear assumption shows the lowest probability at 72.84%.

Average payout

The same table also displayed average payouts by market types.

The average loss under the neutral assumption is 18.3%. But in the bearish and more volatile scenarios, it rises to 21.6% and 21.8%. On the other hand, both the bull and the less volatile scenarios reveal an average loss of 14.6%,

Small or high moves

Hampson explained those correlations.

“The bull and less volatile environment produce a similar outcome for different reasons. In the bull market, your chances of losing money are less because you’re moving away from the risk of losing capital,” she said.

“The less volatile has the same effect but in this case it is because the moves are contained. It is not a participation product. You don’t gain anything from the index going up a lot. You just want to stay above 90.

“You’re going to get there either if volatility comes down or if the price goes up a little bit. In both cases you reduce your chances of losses drastically.”

Back testing

Future Value Consultants includes back testing in its reports for the last five, 10 and 15 years.

In the bull market environment seen in the last decade the results are very positive. Getting the digital payout has occurred with a 99.92% frequency for the past five years, 89.72% for the past 10 years, as those include the financial crisis and 90.66% for the last 15 years.

“These do not predict what the market will do in the future. But they show the strong likelihood of getting your digital payout with this product.

“Investors in the notes are not bullish. They’re not overly ambitious in their target. But the odds of getting paid are compelling and the exposure to risk much less than with an ETF,” she said.

The notes would probably not be an investor’s sole exposure to the U.S. equity benchmark.

“It’s a tool to reduce overall volatility in your portfolio,” she said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48130UF26) will settle on Oct. 25.

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