JPMorgan innovates with contingent interest, contingent leveraged autocalls on Low Vol index

By Emma Trincal

New York, July 19 – JPMorgan Chase Financial Co. LLC introduced a novel structure providing either income for a limited time or leveraged buffered participation at maturity. The outcome is based on the daily observation of a barrier during the first year of the note.

The $1 million autocallable contingent interest and contingent leveraged notes due July 16, 2026 linked to the S&P 500 Low Volatility High Dividend index offers two possible scenarios.

The first one is pure income.

During a first-year observation period, investors will earn a monthly contingent coupon at an annual rate of 16% if the index has not closed below the coupon barrier, 90% of the initial level, on any day during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission. Coupons are payable only during the first year. Therefore, the income scenario is limited to that first year.

Investors receive their full 16% income and get called at the end of the first year if the barrier has never been breached during that 12-month period. The barrier is known as “American” because it can be triggered any day.

Participation at maturity

The second scenario provides leveraged participation with geared buffer at maturity. The buffer is used both on the upside and the downside.

If the notes are not automatically called at the end of the first year due to a trigger event, the payment at maturity will be (a) the sum of the return of the index over the term of the notes plus the buffer amount of 10% times (b) the leverage factor of 1.11111.

For instance, if the index return is 20% at maturity, investors will receive par plus 33.33%.

Key barrier

Despite the unusual 10% buffered upside, sources insisted that what makes the structure novel is what happens during the first year.

“I see it as an income note for one year with a potential call and then it flips to a geared buffer with upside leverage,” a sellsider said.

“I’ve seen geared buffers on both sides before. But it’s not very common.”

The use of the American barrier for a coupon in itself is not uncommon, this sellsider added. But the consequences of a “trigger event” were unusual, he noted.

“The idea that this American barrier is a knockout that will stop your coupon not just for that current month but for all future months during that first year, that’s very unique.

“And it will also kill all chances of being called. That’s unusual too.

“I haven’t seen anything like that before.”

The sellsider compared this structure with another type of product seen in the market in the past couple of years.

“What I’ve seen are notes with a one-time call usually after one year. If you get called, you get a premium. If you don’t get called, you go to maturity. But I haven’t seen the coupon feature for the first year like this one. What we have here is a shift from an income strategy to a growth strategy,” he said.

Rangebound view

One thing sellsiders agreed on was that buyers of the notes were hoping for a call to occur. It was their bet.

“You’re not buying this to stay invested for four years. You want the barrier not to breach so you can get out after one year with your 16%. That’s the goal,” the structurer said.

The sellsider agreed.

“It’s a conviction trade,” he said.

“Someone doing that must be convinced that they can get called in one year,” he said.

“The idea is: we already had a big market pullback. The bulk of the pullback is already in. I don’t believe we can lose an additional 10% from where we are.

The bet was not without risk given the size and the nature of the barrier, he added.

“There’s not a lot of downside protection there. You’re obviously taking that risk for the high coupon,” he said.

Low vol., high dividends

Issuers may have chosen the S&P 500 Low Volatility High Dividend index to offset some of the downside risk.

“It’s tied to a low vol. index, not the Nasdaq. It may contribute to reduce the chances of a 10% drop. At least that’s what you’re hoping for,” said the sellsider.

The structurer did not opine on the nature of the risk. Instead, he stressed that the investment was based on a specific view.

“You want the market to stay stable during that first year. Perhaps the use of a low volatility index can help. Anyone buying the note has to have that conviction. Of course, you can be wrong. But that’s why they’re able to give you 16%. That makes sense,” he said.

“And if you don’t get called, worst comes to worst, you’re in for three more years but you have a 10% buffer, plus leverage on the upside with a bonus,” he said referring to the upside buffer.

The sellsider put the benefit of the upside buffer in perspective bringing the issue of the dividends.

The S&P 500 Low Volatility High Dividend index measures the performance of the 50 least-volatile high dividend-yielding stocks in the S&P 500. Its dividend yield is 4.28%.

“I don’t know what options they’re using but you’re not going to get 4.28% for four years if you invest in the notes. That’s 17%, which largely exceeds the 10% buffer,” said the sellsider.

“It’s not really a growth play. You want to be in a one-year note and then out.”

Buysiders’ view

The absence of a fee listed in the prospectus led this sellsider to assume the deal had been sold to a registered investment adviser.

“It’s probably a fee-based account. It could have been done for an adviser or an institution maybe. A retail buyer is not going to come up with that type of strategy,” he said.

But not every RIA was going to like the note.

“It would be hard for most people to it figure out,” one of them said.

Other buysiders did not like the terms.

“It’s unlikely with this American barrier that you’re going to get your 16% and you’re going to have to wait for another three years. I don’t like longer-dated notes. Chances are you’ll be locked in for four years,” a financial adviser said.

The “complexity” of the structure was also an issue, he said.

“The structure is convoluted, and clients are not familiar with the index. These two things make it difficult to explain,” he said.

Finally, the payout with 1.11 times leverage was not “something to write home about,” he said.

“I know the people at JPMorgan. They try to be creative and come up with new structures. Some are really good. But this one leaves me flat.

“A 10% drop any day for one year seems very likely. And then you’re done.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the underwriter.

The notes settled on Friday.

The Cusip number is 48133LLV2.

© 2015 Prospect News.
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