JPMorgan’s dual directional knock-out notes on S&P 500 fit risk-averse, mildly bearish profile

By Emma Trincal

New York, Sept. 23 – JPMorgan Chase Financial Co. LLC’s 0% dual directional knock-out notes due Sept. 30, 2021 linked to the S&P 500 index may offer a bond replacement strategy or a way to express a mildly bearish view, advisers said.

A knock-out event will occur if on any day during the life of the notes, the closing level of the index is greater or less than its initial level by more than the knock-out percentage, which is 19.5%, according to a 424B2 filing with the Securities and Exchange Commission.

If a knock-out event never occurs, the payout at maturity will be par plus the absolute value of the index return.

If a knock-out event occurs, the payout will be par plus 2%.

Fixed-income alternative

Jerrod Dawson, director of investment research at Quest Capital Management, said that the notes could be used as a fixed-income replacement in a portfolio.

“Worst-case scenario you only get 2% return. But your principal is guaranteed,” he said.

“If you compare it to what you could get from a bond, you’d have to take into account the difference in yield.

“Two percent is probably less than what you would get from the corporate paper. However, the upside potential from the S&P 500 more than offsets the difference in yield.

“I think this is a good, perhaps better, alternative to owning the bond.”

If the knock-out never occurs, the one-to-one positive return both on the downside and the upside is limited to 19.5%. Under this scenario, gains will be made if the index finishes anywhere between negative 19.5% and positive 19.5%.

Dawson considered the notes more as fixed income than as an equity replacement simply due to the possible occurrence of the knock-out event within the next two years. The observation of the knock-out on any trading day as opposed to point-to-point increased the probability of such outcome.

Equity substitute

“This note is more straightforward as a bond replacement,” he said.

“Between September and December of last year, we were really close to a 19.5% drop in the S&P,” he said.

“If you had used it an equity alternative, you would have knocked out and ended up with 2%, missing the 20% rally we’re having so far this year.

“I’m not saying it’s not something that can’t be used on the equity side. It actually may make sense ... maybe as a hedge.

“So much of it depends on your outlook and what your client is trying to do.”

An “aggressive” investor may not want to give up dividends for two years for a product with a 19.5% cap, he noted.

“It would be some 7%-a-year return after taking out the 2% dividend yield. A bull may not want to give up that much,” he said.

“But a more risk-averse client would be happy to have the full principal protection over the two-year period.”

Credit, tenor

Steven Foldes, vice-chairman at Evensky & Katz/Foldes Financial Wealth Management, said that the notes may work for the right kind of investor. In his view, conservative investors would benefit from it the most.

He first mentioned two aspects of the structure he felt comfortable with.

“JPMorgan is a very fine institution with a very good credit quality, so there isn’t any issue with them,” he said.

“We also like shorter tenors. Two years is a term that we like.”

Taxes

What Foldes liked less was the tax treatment associated with notes that guarantee the full return of principal.

“We’re not crazy about principal-protected notes because they’re taxed as ordinary income. You get ordinary income treatment instead of long-term capital gains, which is an issue. You would have to hold it in a sheltered account so that you won’t have to be concerned about the tax consequences,” he said.

Moderate bear

However, the notes may neatly fit a moderately bearish outlook, he said.

“If you are reasonably bearish over the next two years, the note at least guarantees that you’ll get your principal back. If we have a nasty market, you’ll get your principal plus 2%.

“Assuming we don’t have a significant decline of 19.5% or more, you’ll get the absolute return up to 19.5% either way.”

The knock-out event could certainly occur, although it doesn’t happen frequently.

“It did happen a few times in the past decade,” he said.

He mentioned a 20% decline between late September and Christmas Eve last year from “peak to trough.” Other periods included 2011 and of course during the 2008-09 financial crisis.

Safety net

“It did happen. But a decline of this magnitude is rare,” he said.

“If you are bearish, reasonably bearish, there’s a chance this barrier won’t break and you’ll get more than 2%. You’ll get the absolute return.

“If you’re wrong and the market is very strong, you’ll get the benefit of a 10%-a-year return.”

He was referring to the index reaching its cap of 19.5%.

“In most cases you’re going to do pretty well as long as we don’t have an extreme scenario.

“For somebody who is negative about the market, it’s probably a pretty good note.

“Our view is not so negative, but we’re 10 years into a bull market, so a turn is certainly possible.”

Post-elections hedge

The September 2021 maturity of the notes was also timely for investors seeking to hedge against any major political change after the 2020 presidential election.

“Depending on your political persuasion, if the elected candidate is not too pleasing to Wall Street, you could have a significant market decline. The elections are 13 months from now. The new president will be inaugurated in January 2021, which is eight months before maturity. This may be a period of volatility and uncertainty,” he said.

“Any cautious investor would find the downside protection attractive during that time.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48132FNJ1) will price Wednesday.

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