JPMorgan’s 8.25% airbag autocallables linked to United States Steel show high level of risk

By Emma Trincal

New York, May 22 – JPMorgan Chase & Co.’s 8.25% airbag autocallable yield optimization notes due May 31, 2016 linked to the common stock of United States Steel Corp. are a risky product despite several risk mitigation attributes, said Suzi Hampson, structured products analyst at Future Value Consultants.

The notes will be called automatically at par if U.S. Steel shares close at or above the initial share price on any quarterly observation date, according to an FWP with the Securities and Exchange Commission.

Interest will be payable monthly.

The payout at maturity will be par unless the final share price is less than the conversion price, in which case the payout will be a number of U.S. Steel shares equal to $1,000 divided by the conversion price. The conversion price will be 72.5% to 75% of the initial share price and will be set at pricing.

“Considering it’s only one year and we get a kick-out as well, on the face of it, it sounds quite reasonable,” said Hampson.

“The kick-out opportunity of sort gives some kind of protection because you are returned your capital if the autocall is triggered.

“Moreover, the barrier type, here it’s a European barrier, is also beneficial to investors.”

European barriers are observed only at maturity, reducing the odds of a breach, she explained. By contrast, so-called “American” barriers can be hit any day during the life of the notes and as such are considered riskier.

Volatility

“Obviously the main risk factor here is the volatility of the underlying stock,” she said. The one-year implied volatility of U.S. Steel is 44%, compared with 15% for the S&P 500.

“It’s a big difference. At first glance the notes offer quite a low barrier for only one year. But given the volatility of the stock, it may not be enough.”

The underlying security’s performance within the past year illustrated her point. The stock traded at $46.00 in September but dropped more than 29% less than a month later to $32.55.

Cushion

One of the main appeals of reverse convertible is the fixed interest rate they deliver, she said.

But it is debatable whether the coupon should be considered a risk-mitigating factor.

“If you lose capital at the end of the term, you have obviously 8.25% and you have the total 8.25% coupon since it’s a European barrier,” she noted.

“But you don’t start losing money unless the stock drops by more than 25%, since it’s a 75% barrier. At that point you definitely lose capital. The coupon certainly gives you some kind of cushion, but it only offsets the amount of capital lost.

“It’s the autocall provision that’s more of the offsetting factor when it comes to risk.

“If the product kicks out, it means the underlying is flat or has increased above the initial level. Everything will be OK if it occurs because the stock is already doing OK.”

Income play

Investors in the notes are distinct from stock investors as they seek income first. Yet they should be just as familiar with the underlying security, she said.

“Reverse convertibles were popular because they offer a fixed return usually combined with a decent barrier. Often it’s an American barrier. This one at least gives you the European type, which is better,” she added.

“Investors in this product are looking for income. That’s what the structure is designed for.

“Anyone buying this product needs to have a view on the stock and can’t be bearish.

“People who will look into these notes versus the stock are certainly drawn to the income and the downside protection.”

Market riskmap

Future Value Consultants calculates the market risk and the credit risk and adds the two components to generate the “riskmap,” which measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible.

The product received a market riskmap of 6.83, compared with a 4.46 average score for the product type, according to the firm’s research report.

“It’s high. As we noted, it’s the volatility,” she said.

“Other factors such as the kick-out, the barrier type, the barrier level and the maturity reduce the risk, but they don’t offset the risk that much.

“The score is at the riskier end of the product type, and this product type – all reverse convertibles – is riskier than the ‘all products’ category.”

The “all-products” type is a category used in the ratings that represents all notes across all structure types recently rated by Future Value Consultants.

Credit risk

The credit risk for the notes is 0.26, which is almost equal to the average for the product type of 0.28, the report showed.

“The low credit risk is based on the short maturity. It’s a positive for the product,” she said.

“Once you add the market riskmap and credit riskmap, you find a pretty significant level of risk.”

The riskmap is 7.09, way above the 4.74 average score for the product type.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The score is calculated using five key market assumptions: neutral, bullish, bearish, high volatility and low volatility. The best of the five scenarios is selected to measure the risk-adjusted return on a scale of zero to 10. This product’s score is based on the bullish scenario.

The product has a 4.30 return score versus an average of 5.69 for its peers, according to the report.

“It’s less than average because you need a higher return to compensate for the elevated risk level,” she said.

“Your return is capped at 8.25% per year. This would be your maximum if you get called at the end of the one year.”

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10.

At 2.59, the price score is much lower than the 5.25 average for the reverse convertible category.

“Of the two, risk score and price score, the return score is the better,” she said.

“The kick-out gives the product a shorter expected duration, which pushes down the price score.”

Shorter-dated products tend to score lower than longer types of products on the price scale, she explained.

“That’s because the fees, which are calculated on an annualized basis, are not spread over a long enough period of time,” she said.

“The issuer probably did not spend enough on the options, and those two factors combined lead to less value to the investors.”

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The product scores 3.45 on the overall scale versus the 5.47 average score for its peers.

“With a price score almost half lower than average and a pretty low return score, this product is not scoring very well,” she noted.

“Scores would have been better with a higher coupon. For that level of risk, investors are probably not given enough return.”

The notes (Cusip: 48127X740) will price May 27 and settle May 29.

UBS Financial Services Inc. and J.P. Morgan Securities LLC are the agents.

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