JPMorgan’s $2.16 million digital notes on Russell, S&P show strong bearish tilt

By Emma Trincal

New York, Feb. 28 – JPMorgan Chase Financial Co. LLC’s $2.16 million of 0% digital barrier notes due April 12, 2024 linked to the lesser performing of the Russell 2000 index and S&P 500 index provide a deep contingent protection making the product eligible for bears although not all of them. Using it as a hedge may be another option but only for investors with a rangebound or agnostic view on the market.

If the worst performing index ends above its 60% barrier, the payout at maturity will be par plus 8.5%.

Investors will lose 1% for every 1% that the worst performing index declines if it finishes below the barrier, according to a 424B2 filing with the Securities and Exchange Commission.

Worst-of

“40% is a pretty good barrier,” said Kirk Chisholm, wealth manager and principal at Innovative Advisory Group.

“But the S&P can still go down 40%. I think the Russell may be the better one because the bigger companies are the ones that are the most overvalued,” he said.

The bearish bias of the product gave investors a chance to outperform in a down market, he said.

“While I don’t like the worst-of, I can see how this note could have a reasonable probability for success.”

Failing the test

And yet, for Chisholm, who is bearish, the barrier failed to provide sufficient protection.

“I don’t love the note. I can see why people may be interested. But it doesn’t bring any solution to the problem I’m trying to solve,” he said.

The main “problem” for Chisholm was to counter a significant market plunge, which he anticipates will easily exceed 40%.

“In my opinion sometime in the next five years, the market will drop anywhere from 40% to 60% from where we are,” he said.

“This barrier doesn’t protect me.”

Risk-reward

This is why, he said, there is no reason to take on equity risk over the next 13 months for a potential 8.5% return.

“I don’t see the point, especially when you’re competing against U.S. Treasuries yielding 5% with virtually no risk.”

The yield on the one-year T-bill is 5.05%. The shorter six-month tenor has an even higher yield of 5.162%.

“If we were in a zero-interest rates environment, that may be different. But since you can get 5% on the risk-free rate, I would take a pass just for that reason,” he said.

As always other advisers may hold a different view.

“If you’re trying to find an investment, this is just that: an investment. But if you’re trying to reduce risk in the portfolio as I do, this is just not going to work,” he said.

Too bearish

For Jonathan Tiemann, president of Tiemann Investment Advisors, the note may be slightly too bearish although useful as a hedge for the U.S. equity portion of a portfolio.

“It’s definitely bearish. The worst-of makes it more likely to see a loss, but I can’t really see either one index dropping 40%. It would be stunning,” he said.

He explained the tradeoff.

“You’re giving up your upside to get the protection and the digital return.”

Assessing the value of the barrier was a matter of personal preference.

“It depends on your view. You have to ask yourself whether it will be enough to protect you. Personally, I think that if the market was down 40% in that period of time, we would have bigger problems to worry about than this note.”

For a directional bet, the note was nothing but bearish, he said, and perhaps too bearish.

“I don’t know if we’re really in a bear market at this point,” he said.

“We had a big downturn. But now? Are we enjoying a little break before a bigger decline, or have we seen the worst of all? I’m inclined to think it’s the latter.

Hedging tool

“We may very well have a recession, but I don’t think it will be a severe one and a recession has already been priced in,” he said.

This did not make this adviser bullish.

“I don’t know if we’re going to have a big advance for a while.

“The Fed has been pretty consistent in saying they’re not even beginning to think of when they’ll start cutting rates. Instead, they’re thinking of how much they have to raise them,” he said.

A clearer benefit of the note could be to use it as a hedge.

“40% is pretty generous. If you have a long equity position in a taxable account with big unrealized gains, you could use the note to take some chips of the table and not realize those gains,” he said.

Finding balance

Perhaps the main drawback of the structure was the unbalance between the range of protection and the potential return.

“My view is that the upside is not overly generous. 8.5% is not terrible but it’s not great,” he said.

He suggested reducing the barrier size in order to increase the digital payout. However, he declined to indicate what in his opinion would constitute a good range.

“I would have to look at how the options are pricing,” he said.

Interestingly JPMorgan issued another deal on the same day doing just that. This other offering (Cusip: 48133UGT3) priced for the same size and reduced the contingent protection amount to 28.5% from 40% while boosting the coupon to 11%. The terms (maturity date, underliers, and fee of 1%) were the identical to the notes with the 40% barrier (Cusip: 48133UGU0).

JPMorgan Chase & Co. is the guarantor and J.P. Morgan Securities LLC the agent for both deals, which settled on Feb. 23.

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