JPMorgan’s dual directional notes on Stoxx Europe Utilities may offer alpha in defensive play

By Emma Trincal

New York, July 31 – JPMorgan Chase & Co.’s 0% dual directional trigger Performance Leveraged Upside Securities due Oct. 4, 2017 linked to the Stoxx Europe 600 Utilities index enable investors to outperform the index in a pullback scenario via an absolute return component, sources said.

However, the noteholders have to give up the 5.65% dividend yield offered by the index. The trade-off is uncapped upside leverage at a rate of 130% and positive returns if the index falls by up to 20%, according to an FWP filing with the Securities and Exchange Commission.

If the index falls by up to 20%, the payout will be par plus the absolute value of the index return. Otherwise, investors will be fully exposed to losses if the index finishes below the 80% trigger level.

The Stoxx Europe 600 Utilities index is one of the Stoxx Europe 600 sector indexes. It tracks a broad range of European utilities companies.

Access plan

Giving up the yield paid by the index may seem like a high price since European utility companies tend to pay fatter dividends than in the United States, but sources said that it makes sense for investors seeking exposure to the sector.

Access would be the first reason to invest in the notes, according to a source, pointing to the fact that U.S. investors do not have any exchange-traded fund alternative to get exposure to the Stoxx Europe 600 Utilities.

“There are currently seven ETFs available that are based on this index, however, none of them is listed in the U.S.,” said a spokesperson at Deutsche Börse.

The Stoxx Europe 600 Utilities index was created by Stoxx Ltd., a joint venture between Deutsche Börse AG and SIX Group AG.

Sector potential

For Steve Doucette, financial adviser at Proctor Financial, investors can generate a significant amount of “alpha” on the downside, making the notes appealing as a potential hedge. The unlimited and leveraged upside is also attractive given the historical performance of the sector.

“Utilities tend to be used as a defensive play by nature,” he said.

“The sector has outperformed the market historically. At least it has been the case over the long run. Take the U.S. for instance and look at the Dow Jones Utility Average versus the S&P 500: the Dow Jones Utility has outperformed the market over a 10-year period. Utilities stocks are defensive, but they also offer good upside potential partly because they pay high dividends. Even the short-term trend shows that utilities are beating the broader index at this point.”

For the year to date, the Dow Jones Utility Average is up 10.5% while the S&P 500 has increased by 5%.

In Europe, the same trend holds true for the year to date, as utilities have significantly outperformed the broader market. The Stoxx Europe Utility 600 index is up 14% versus 2.35% for the Stoxx Europe 600, which is the broader European equity benchmark.

“Here, they’re stripping out the dividends, but you’re getting decent terms in exchange,” Doucette said.

“It looks like a nice note. You can capture the trend of utilities outperforming the market. If the market sells off, those stocks tend not to be hit as hard due to the dividend components.

“You’re giving up the dividend when you invest in the notes, but you capture the barrier and the absolute return, which could lead to significant outperformance if the market falls back.”

European diversification, yield

The notes’ underlying investment theme may be used by a conservative investor to diversify away from domestic stocks, said Al Baker, investment adviser at SWS Financial Services.

“Utilities are not growth stocks. You would expect them to underperform the market. But if you add dividends back in, it’s not as bad. They give you some protection in the sense that if the market goes down, utilities will go down less,” Baker said.

“Returns on this sector are good this year. People are buying utilities stocks because they fear that the market is going to crash. It’s seen as a conservative option.

“It’s a European play too. It could fit into an international equity bucket. It would be a good way to diversify your portfolio. We like Europe, but we keep our global allocation to 15% maximum. And in that, we don’t just have Europe, we have emerging markets too. I own emerging market debt, not just international blue chips.”

Locked in

Baker said that European equity is also attractive for U.S. investors from a value standpoint. But regarding the structured notes, duration is a concern.

“At this point, these stocks are probably valued properly compared to us. European valuations are just about right,” he said.

“This note offers an interesting trade-off with the absolute return, but you’re locked in for three years basically, and I’d be careful with that. You can use it as hedge for your portfolio, but you don’t want to get into a situation where you can’t get out if you want to break the hedge.

“You’re also not getting paid any dividend or coupon during the three-year holding period. For someone who relies on income – and dividend investors fall into that category – that wouldn’t be good.

“I guess these notes may be a good fit for long-term investors who don’t have a need for immediate income. There is a place for these types of exotic products in some portfolios but in a limited way. You wouldn’t want to put more than a 5% allocation in there.”

J.P. Morgan Securities LLC is the agent.

The notes were expected to price Thursday.

The Cusip number is 481246585.

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