JPMorgan’s contingent income autocallables tied to Delta show 50% chance of lasting a quarter

By Emma Trincal

New York, Oct. 4 – JPMorgan Chase Financial Co. LLC’s contingent income autocallable securities due Oct. 8, 2020 linked to the common stock of Delta Air Lines, Inc. have the same characteristic as their peers: a high likelihood of a call on the first call date, said Suzi Hampson, head of research at Future Value Consultants.

If the shares close at or above the downside threshold level, 75% of the initial share price, on a quarterly determination date, the notes will pay a contingent payment that quarter at an annualized rate of at least 10.15%, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par of $10 plus the contingent coupon if the shares close at or above the initial share price on any quarterly determination date other than the final determination date.

If the final share price is greater than or equal to the downside threshold level, the payout at maturity will be par plus the final contingent coupon. Otherwise, investors will lose 1% for every 1% that the final share price is less than the initial share price.

Reverse convertibles 2.0

Hampson drew parallels between the note, which combines an autocall with a contingent coupon (a structure known as “phoenix autocallables”), and traditional reverse convertibles.

“Today autocallable contingent coupon notes have overtaken the old market for reverse convertibles,” she said.

“They are the most common ways of getting income. They may have stated maturities of one or two years, even longer. But they tend to kick out much earlier.”

Traditional reverse convertibles used to dominate the U.S. market. With three- or six-month maturities, they offered a fixed coupon extracted from the premium of typically highly volatile single stocks, she said.

“The phoenix autocalls are the 2019 version of the old reverse convertibles we used to see back a few years ago,” she said.

“They now dominate the U.S. supply of income-oriented structured notes.

“Unlike reverse convertibles, those are autocallables. But their duration is short on average.”

The difference is the uncertainty of the maturity and the contingency of the coupon, she said.

“Issuers had to introduce those factors to get higher yield in a lower-rate environment. It also gives you a decent downside protection. You can get relatively deep barriers. This one, at 75%, looks reasonable.”

Another difference is the barrier type. Reverse convertibles had American barriers, which means observations throughout the life of the notes and not point to point.

“Reverse convertibles were slightly different in many ways. But we don’t see that many anymore. They used to be a huge percentage of the market. Not anymore.”

Stress testing

Future Value Consultants offers stress testing reports on structured notes. Each report consists of 29 sections or tests.

Hampson looked at one of them called product-specific tests, which displays the probabilities of all possible and mutually exclusive outcomes.

This report comes as a Monte Carlo simulation under five different market scenarios. First, there is the neutral scenario, which reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

Second, there are four other market scenarios that are determined based on different underlying growth rates and volatilities. Those are bullish, bearish, less volatile and more volatile.

Short duration

“This note gives us pretty standard probabilities. The probability of calling at point one is about 50% in a neutral market environment,” she said.

“For a single-asset product, this 50% probability makes sense in a neutral growth scenario. It’s the equivalent of saying you have 50% chances of being where you are or higher in three months.”

The probabilities of a call are 12.74% at point two and 5.74% at point three, according to the table.

“This is also typical: the probabilities of calling get increasingly lower if it doesn’t happen at point one. The window of occurrence narrows after the second, third and last opportunity,” she said.

Barrier evaluation

The 28.6% implied volatility of the underlying stock “is not excessively high,” but it’s “high enough” to introduce risk, she said.

“It’s a good barrier, but it’s not unbreakable.”

The probability of barrier breach is 15% in the neutral scenario and 11% in the bullish scenario.

“Our bull scenario relies on a very conservative growth rate of 6.1%, which is not the common acceptation of the term bullish. It’s part of our methodology to pick conservative assumptions for growth,” she said.

The 11% chance of breaching means there is still a risk even under the best market assumption.

“But you wouldn’t be able to give a 10% coupon without risk. Yet 11% doesn’t seem too bad,” she said.

Having no coupon at all carries a “very limited” probability of 2% in the neutral scenario and 1.4% under the bullish assumption, according to the tests.

Back testing

Another table in the report displays the back-tested version of the product-specific tests over the past five years and 10 years.

Over the past five-year period, the automatic call occurred 59% of the time. The frequency rose to 62% under the bullish scenario.

“This is not a huge difference. The high frequency of call at point one is consistent with a stock that has gone up during this period of time,” she said.

Back-testing analysis also showed extremely positive results for barrier breach outcomes. The underlying stock never fell below the 75% downside threshold over the five-year period, and it only occurred 4% of the time in the past 10 years.

Risk of losses

Any product shorting volatility is based on the same fragile balance: investors need volatility to generate an attractive coupon. But too much volatility increases the risk of losing principal or skipping some coupon payments, she said.

“You really want for those products the same outcome of what you want from a reverse convertible,” she said.

“You buy the note hoping the underlying will stay where it’s at or move slightly up for the foreseeable future.

“You don’t want too much volatility, although that’s what generates the coupon.”

Issuers constantly adjust barriers based on the desired level of income or the other way around.

“The investor wants the stock to stay above the 75% barrier if the note isn’t called,” she said.

“If there’s a loss, it’s going to be big – at least 25% of your principal since you breached the barrier point to point.”

Investors may lose a little bit less, but not a whole lot less, she said.

“Our stress testing showed that you have close to zero chances of not earning at least one coupon, so you’ll lose 25% minus any coupon you might have. It’s still going to be a steep loss.”

But the tests also showed a 10% to 11% probability of hitting the barrier.

“The most likely outcome is that you’ll get some proportion of the annual coupon and your capital back, which is what investors are looking for.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent. Morgan Stanley Smith Barney LLC will receive a structuring fee.

The notes are expected to settle on Oct. 9.

The Cusip number is 48132G492.

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