JPMorgan’s barrier leveraged notes on gold, silver ETFs need more protection, sources say

By Emma Trincal

New York, Aug. 24 – While investors appreciate pure leveraged plays with no cap combined with downside protection, one example of such structure may be lacking on the defensive front, sources said.

JPMorgan Chase Financial Co. LLC’s 0% uncapped contingent buffered return enhanced notes due Aug. 29, 2025 linked to the lesser performing of the SPDR Gold Trust and the iShares Silver Trust could benefit from a stronger type of downside protection given the structure and the nature of the two underlying funds, they said.

If each asset finishes above its initial level, the payout at maturity will be par plus 1.78 times the gain of the lesser performing asset, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the lesser performing asset falls by up to 40%.

Otherwise, investors will lose 1% for each 1% decline of the worse performing asset from its initial level.

Credit, no cap

“There are a few positive things in the note,” said Steven Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management.

“I like JPMorgan. It’s a good credit. Also, conceptually I like the idea of unlimited upside with substantial leverage. So, having 1.78-times leverage without any cap is very nice.

“Finally, there are also no loss of dividends because precious metals don’t pay dividends. That’s great especially on a longer maturity.”

Fee, five-year term

But some features were less appealing.

“What I don’t like is the commission. It’s way too high,” he said.

The fee is 4.125%, according to the prospectus.

“Also, the term is a lot longer than we normally like.”

Looking at the two underliers Foldes noted that commodities-linked notes are rare. Most structured notes are linked to equity underliers, in particular indexes.

“We don’t typically invest in commodities although there is nothing wrong with this asset class,” he said.

“We like to look at notes on the S&P. Commodities are quite different. The structures can’t be the same.”

Rally, volatility

Foldes said he likes to see shorter term notes on the S&P 500 index with uncapped and leveraged returns.

The need for a downside protection is not a priority for him when it comes to U.S. equity-linked notes.

“It’s very different with precious metals. Both gold and silver have significantly appreciated over the last 12 to 24 months. They are near or at all-time highs. Valuations matter when you want to buy a note, which is like entering a trade. I would be extremely cautious especially given the high volatility of both gold and silver,” he said.

Entry prices

The SPDR Gold Trust recently rose above a September 2011 all-time high. It closed at $181.20 per share on Monday, gaining 26% for the year.

The iShares Silver Trust, which hit a 52-week high two weeks ago, is now trading at its highest level since the spring of 2013. It’s up 47% for the year.

“These entry levels are very high. Volatility levels are high. A 60% barrier doesn’t really give me enough downside protection,” he said.

“You also have to deal with correlations. I don’t know about those two funds, but they may not even be highly correlated.”

The coefficient of correlation between the two ETFs is 0.828. Two U.S. equity indexes would move more in synch. The S&P 500 index and the Dow Jones industrial average for instance have a coefficient of correlation of 0.989.

Buffer warranted

“If I was thinking about changing this note, I would want to replace the barrier with a buffer. Having a buffer would make me much more comfortable because any of those funds can be down 40% five years down the road,” he said.

“At least a buffer gives you a hard protection.

“Having 1.78 times leverage, no cap and a 40% barrier is terrific. Except that you’re buying at very, very high levels two funds that can have big swings.

“This note doesn’t give me enough downside protection. Valuations and volatility are too high,” he said.

Bullish trend

A commodities portfolio manager said that the macroeconomic environment was favorable to gold and silver at the moment.

“There’s been a lot of interest in precious metals with both gold and silver doing very well,” he said.

“This bull trend has been driven by interest rates. Both nominal and real interest rates are extremely low, making non-interest-bearing assets such as gold and silver attractive.”

Also supporting precious metals is the central banks’ “expansion,” he noted.

“It’s unprecedented. Even in 2008, central banks didn’t go that far. Back then, it was mostly the U.S. and Europe implementing accommodative monetary policies. Today, every central bank in the world has been expanding their balance sheet at the same time. So not only those central banks’ policies are all happening at the same time but also at an unparalleled scale.”

Those factors are positive for precious metals, which tend to be used by investors as inflation hedges.

“To make things even better, the Fed is expected to keep rates down for the foreseeable future, even as far as the five-year timeframe of this note,” he said.

Correlation

But other aspects of the deal were not as attractive.

“The correlation between gold and silver, which are both rising in price, may be high but not as high as you would think.

“Gold is a precious metal and so is silver. But 50% of silver is used for industrial production. Silver is benefiting from a huge industrial rebound, especially in the emerging markets, not so much in the U.S. as we are a service economy.

This factor has given silver a boost, which may in part explain why it has appreciated almost twice as much as gold this year.

“But silver is also particularly volatile.”

Term, barrier

The use of the two ETFs in the note was not a bad idea, he said.

“In general, being long precious metals makes sense,” he said.

“However, investing in a five-year note is taking a very long-term view for two relatively volatile assets, especially silver.

“Also, the entry points for both funds are pretty expensive.

“So, given all those risk factors, I think the barrier is kind of short.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price on Aug. 26.

The Cusip number is 48132M7A3.

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