JPMorgan's 11% autocallable reverse convertibles linked to VeriFone show high market risk

By Emma Trincal

New York, May 3 - JPMorgan Chase & Co.'s 11% autocallable single observation reverse exchangeable notes due May 15, 2014 linked to VeriFone Systems, Inc. may not add enough value for investors given the high volatility of the underlying stock, said Eve Berlinska, structured products analyst at Future Value Consultants.

Based on the firm's research, she suggested that a higher coupon should have been paid or more protection offered given the risk.

Interest is payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par if VeriFone stock closes at or above its initial share price on any quarterly review date.

The payout at maturity will be par unless the final share price of VeriFone is less than the initial price and the share price dropped below the 65% threshold during the life of the notes, in which case the payout will be a number of VeriFone shares equal to $1,000 divided by the initial share price.

"This product is a hybrid. It combines a reverse convertible, which pays a fixed interest, and an autocallable feature. Investors get paid a coupon regardless of the performance of the stock. The autocall allows for an early redemption if the underlying closes above par on the quarterly date," Berlinska said.

"What is important here is the high volatility of the underlying stock. The one-year volatility on VeriFone is 47%. It's pretty high compared to 16% for the S&P 500."

VeriFone is a business equipment company that provides electronic payment technology.

Volatility risk

The prospectus warned in its risk section of "volatility risk." As the share price can fall sharply at any time, the product is more risky than a note tied to a broad index or tied to a less-volatile stock, she noted.

"Investors get compensated for the risk either in terms of coupon or downside barrier," she said.

She noted that the barrier in the product was not a "final-day barrier" but one that can be observed daily.

"The protection can end any time. If the stock drops below the 65% threshold during the one-year term, investors lose the protection and any decline in the stock price at maturity is their loss, although they get the 11% cushion from the coupon, just like investors in a regular reverse convertible," she said.

Investors in the notes cannot be overly bullish given the capped upside. They also have to accept the variability of the tenor as they don't know in advance if the investment period will be three, six, nine or 12 months, she explained.

"This is for someone who wants to have fixed income. It's for someone who does not anticipate the stock to go up in price very much because you don't need growth to get your return; you just need the stock to stay at the same level. So it's not designed for a bullish investor," she said.

Instead, investors considering the security would be primarily interested in generating income regardless of the performance. They would also have to be willing to be exposed to full downside exposure for a limited return.

"The duration is variable for this product. This uncertainty around the tenor is also something investors need to be comfortable with. We don't know if it's going to be called or not," she added.

"It could be called in three months. Each quarter, the call has the potential to trigger an early redemption, which investors need to be ready for because they may or may not be able to reinvest in the same conditions at the same rate of return. That's the reinvestment risk. In that sense, the product is different from the traditional reverse convertibles, which is typically not callable. This one gives you an opportunity to get your capital back early. It works for some investors but not for everyone," she said.

The key metrics of risk, returns and price are measured through various scores, which are established by Future Value Consultants. The research methodology generates reports designed to assess the quality of a product compared to the rest of the market.

The notes fit into the "review reverse convertible" category in Future Value Consultants' methodology. Those are defined as reverse convertible notes offering fixed income with an autocallable feature.

High market risk

Future Value Consultants rates the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

While the credit risk is low, the market risk is higher than average, she said, comparing the product's riskmap of 5.55 with the average score of similar products (3.38) or all products (3.96).

At 0.25, the security displays less credit risk than its peers, which score 0.37 on average on that scale. The notes also offer less credit risk than the all-products category, which has a 0.54 average credit riskmap.

"The credit riskmap depends on the term of the notes and the creditworthiness of the issuer," she said.

"The longer the notes, the higher the credit risk. This product is only one year, so that's one factor that pushes down credit risk. A second one is JPMorgan's credit, which is rather good based on its credit spreads, which are tighter than other financial institutions," she said.

For instance, JPMorgan's one-year credit default swap spreads are only 88 basis points versus 160 bps for Bank of America, she noted.

"The greater riskmap seen with the notes compared to the average is essentially a function of the greater market risk," she said.

The market riskmap for the notes is 5.30 versus the average scores of 3.01 and 3.43 for comparable products and all products, respectively.

"The notes present more market risk mainly because the stock is much more volatile than others, and it's certainly much more volatile than any index. This is why the market risk is so elevated compared to other products," she said.

Given that a barrier breach requires a 35% drop in the share price, it is likely that in such event, investors would lose a "substantial" amount of principal, according to the prospectus. In theory, they may lose their entire principal.

The review reverse convertible category comprises a fair amount of worst-of products, she said, adding that those are considered more risky because of their multiple underliers.

"We're seeing that this product presents more market risk than its peers, including worst-of notes, which would suggest that the main factor at play here is the high volatility," she said.

If the notes had priced a year ago, they would have already breached the 65% barrier. It would be way below the initial price if it matured today.

A year ago, the stock traded at $49.59 a share. It is now down 55.5% at $22.05 as of Friday's close.

Return, price

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios

The best scenario for the notes is bullish as it reduces the odds of a barrier event. Under this assumption, investors have a roughly 57% chance of making between zero and 5% a year and a 21% chance of being in the 5%-10% bracket for annualized return, according to Future Value Consultants' probably outcome chart. The probability of making between 10% and 15% is only 5.2%.

On the downside, there is a 14.5% risk of losing more than 15% and a 2.5% chance of losing less than that.

The return score of the notes at 5.29 is less than similar products, which on average show a 6.22 return score. It's even lower than the average of all products of 6.60.

"This is because we're dealing with a much more volatile underlying than average. Sometimes similar products have a final barrier or a lower call threshold, although it's not usually the case," she said.

"Because the return score is a risk-adjusted return, it takes into consideration what you're getting compared to the market based on the risk you're exposed to," she said.

Investors are exposed to downside market fluctuations since the repayment of their investment depends on the performance of the stock even if their coupon doesn't, she said.

"Because the notes do not offer any upside participation - all the investors get is the fixed interest payment - the value of the coupon is key to determine the risk-return profile of the product.

"For the risk investors are taking here, it appears that they're not getting enough income from the issuer," she said.

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The 4.89 price score is lower than the 6.16 average score for this product type.

"It's obviously lower than the average. The higher the price score, the lower the fees, the greater the value," she said.

"This score indicates that the product's value is low. The issuer could have improved pricing by offering either a higher coupon or a lower barrier or alternatively, a different type of barrier."

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

"The overall score on these notes is not very good," she said, comparing the 5.09 score with that of the average for similar structures, which is 6.19.

"When compared with the 6.65 market average, the quality of the product is even more disappointing."

J.P. Morgan Securities LLC is the agent.

The notes will price May 10 and settle May 15.

The Cusip number is 48126D3A5.

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