JPMorgan’s notes on S&P 500 may yield double-digit gain, but geared buffer could be an issue

By Emma Trincal

New York, May 9 – JPMorgan Chase Financial Co. LLC’s 0% capped buffered return enhanced notes due Feb. 17, 2023 linked to the S&P 500 index provide attractive terms both on the upside and the downside, according to advisers. But investors need to be comfortable with the downside leverage, which is not always the case.

If the index finishes above its initial value, the payout at maturity will be par plus 1.5 times the index gain, subject to a maximum return of at least 46.5%, according to a 424B2 filing with the Securities and Exchange Commission. If the index declines by up to 18%, the payout will be par. Investors will lose 1.21951% for each 1% decline beyond 18%.

Simple solution

“Some advisers get all hung up on these geared buffers because it’s harder to explain,” said Steve Doucette, financial adviser at Proctor Financial.

“But by putting a gearing there, you’re adding up protection or maybe you’re getting a higher cap.

“People get worried because theoretically you could lose all your investment ... that’s what the gearing does. But it takes a while before you get there.”

A hypothetical comparison between a barrier, a traditional buffer and a geared buffer, assuming the same amount of protection, shows there is a greater difference between barriers and buffers than there is between the two buffer types.

The adviser offered the following example based on a 35% index decline, which occurred during the last bear market.

With a barrier level at 82% of the initial index level, investors would lose 35%.

On the other hand, the multiplier applied to the notes’ buffer would generate a loss of 21%.

It’s of course the traditional 18% buffer that would create the best outcome with a 17% loss.

“There’s not a huge amount of difference, and you’re getting more protection with the geared one. If we’re in a bear market, who’s going to care whether you get an extra 3% or 4%?

“I’m not sure why those geared buffers are not more popular. You never know how the client is going to look at it. But if you look at it rationally, it makes a lot of sense.”

Back of the envelope

The example is just a “rough estimate” in order to compare the respective benefits of the three main types of protection, he noted.

In reality, protection levels would differ between a barrier, a buffer and a geared buffer.

For instance, the issuer would not be able to provide 18% in hard protection without the gearing all things being equal.

The buffer would be smaller in size or some other terms would have to be modified, making the structure less appealing, he explained.

A barrier on the other hand should in theory provide a greater amount of downside protection given the greater risk associated with a knock-out.

Timing is hard

“It’s a pretty good generic note. You’re looking at capturing some leverage on the upside, protecting some of the downside, and you’re capping up the upside,” he said.

The notes provide an alternative to a long position in the market.

“This bull run is more than 10 years old. Typically you don’t see returns that mirror the past for an indefinite amount of time. That’s why the leverage is key,” he added.

As always, however, the “hard part is timing,” he noted.

“Bear market cycles typically last one, two, maybe three years at the most,” he said.

Investors are left with the question, is this buffer amount sufficient for the length of the holding period?

“I think this one is decent in case things get ugly for the next four years.”

Adding something

Overall, Doucette said he liked the notes.

“It’s a nice plain-vanilla deal. You probably will do better than the index because you have the potential to outperform in either direction. That’s what I like with these simple notes,” he said.

If he wanted to improve the terms of the product, he would consider adding an underlying index.

“The terms are fine as they are. But you can always use better ones. I might look at expanding the limits between which you outperform, like raising the cap or increasing the buffer, and you can do that with a worst-of,” he said.

“By adding multiple indices you can usually expand the range on either end.”

People’s minds

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the structure was “OK” except for the geared buffer.

“I would be more comfortable with a straight buffer,” he said.

Having to explain the gearing to a client was not the main drawback. Rather, the obstacle was psychological.

“People generally have an aversion to losses. So when you’re embedding a multiplier on the downside, the natural instinct for an investor is aversion.

“It may give you a better pricing, but when you tell an investor we’ll take your loss and multiply it, that’s something they’re going to see and dislike.

“If you do the math, you have a good case to say that it’s not going to be impactful unless it’s the worst-case scenario.

“But behaviorally people are going to resist the idea no matter how well you can explain it.

“People act or react in not-so-rational ways when you talk about losing.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The exact cap will be set at pricing.

The notes (Cusip: 48132CLW1) will price on May 14.

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