JPMorgan's 6.1% reverse convertibles linked to American Eagle receive top scores for category

By Emma Trincal

New York, Dec. 13 - JPMorgan Chase & Co.'s 6.1% reverse convertible notes due June 24, 2014 linked to American Eagle Outfitters, Inc. shares received well above average scores in terms of risk reward profile and value to the investor, said Suzi Hampson, structured products analyst at Future Value Consultants, commenting on her firm's report for this security.

While the terms of the product seem attractive, she said, the unusually high ratings may also reflect a recent move in volatility given the high sensitivity of these structures to the implied volatility of the reference stock, she noted.

The payout at maturity will be par in cash unless American Eagle shares fall below 65% of the initial price during the life of the notes and finish below the initial price, in which case the payout will be a number of American Eagle shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

"Investors in the U.S. are fairly familiar with reverse convertibles. There are so many of them," she said.

"It's worth mentioning that the investor has to have a reason to pick the underlying stock. You are at risk for this single underlying. You can't choose a reverse convertible just based on the coupon."

Investors in a reverse convertible buy a short-term note while selling a put option to the issuer. The coupon on the notes is derived from the value of the put premium.

"This product is designed for yield-seeking investors. They will get paid 3% over the six-month term," she said.

"The higher the volatility, the greater your coupon."

As with most reverse convertibles, the notes feature a downside trigger called an "American option," as it can be hit any time during the life of the deal.

"While the American barrier increases the odds of hitting the barrier, the 65% level is quite low and therefore attractive compared to similar structures," she said.

The issuer filed the prospectus on Dec. 6. Future Value Consultants scored the product on Dec. 11.

"This gap in time may have helped the scores for this product," she said.

"When we scored the product, the implied volatility for this underlying stock was 28%. It looks like the volatility of this name itself is quite volatile. When the issuer put together the deal, the volatility was higher at 35%. It's been moving up and down quite a lot over the past few days.

"Volatility is very important when pricing those products. You are shorting a put, and therefore, your premium increases with volatility. Ideally, you want volatility to be high when you put together the deal and then, you'd want it to fall so you can get better terms.

"It looks like this is what happened with this particular product, which would explain the high price score that we have."

Market move

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. The score takes into account the fees charged per annum. The higher the score, the lower the fees and the greater the value of the instrument.

The product's price score of 8.32 compares "extremely well" to the average for this product type, which is 5.90, she said.

"The disparity in price score between this product and its peers is huge, especially with price scores. This one is perhaps one of the best we've seen in the reverse convertible category," she said.

"Reverse convertibles don't tend to have higher price scores because of the maturity factor. These products are so short in term that is quite difficult to get a high price score since we compute the fees per annum.

"In the few days between the filing and our report, volatility dropped several points. Sometimes, it's enough time to make a difference. It looks like the lower volatility has increased the value of the barrier. As a result, the product is worth more.

"It doesn't mean the product has little value other than that. You still want the issuer to take as few fees as possible. But if the market moves in your favor, it's a win-win.

"Given this high score, we think the volatility factor and the good pricing both contributed to offer good value to the investor."

Low market risk

The riskmap is Future Value Consultants' measure on a scale of zero to 10 of the risk associated with a product with 10 as the highest level of risk possible. It is the sum of two risk components, market risk and credit risk.

The riskmap of the product is "much lower" than average, she said, citing a 1.42 riskmap for the notes versus a 4.65 average score for products of the same type.

The market riskmap for the notes is only 1.13, compared with 4.35 for the average, according to the report. In terms of credit risk, the notes are average. Their credit riskmap is 0.29 versus 0.30 for the average.

"From a risk standpoint, the market risk is relatively less than the average similar product type," she said.

"This could be the volatility. Even at 35%, this implied volatility is still much lower than many other underlying stocks used in reverse convertibles. It's not rare for instance to find underlying stocks with a 60% implied volatility.

"In addition, the 35% protection is not bad compared to similar notes, especially on the six-month term.

"As a result, the probability of breaching the barrier is reduced. That's a combination of a low barrier and not so high volatility.

"The coupon is also a risk-reducing factor. Investors get at the end of the six months a 3% coupon regardless of the stock performance. In any scenario in which you lose capital, this coupon will give you an extra cushion against losses. So at maturity the stock needs to finish at or above 62% rather than 65% in order for you to break even and not lose any principal.

"The credit risk, which is just the average, has to do with the very short six-month maturity.

"Overall, your riskmap of 1.42 is much lower than the average of 4.65 for this product type. The credit risk is definitely a smaller part of the risk in this product."

Good risk reward profile

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios. For this deal, low volatility is the optimal scenario, she said.

Under this assumption, investors have a 95.6% chance of getting an annualized return comprised between 5% and 10%, which would actually be 5% to 6.1% for this bucket. On the downside, the odds of losing more than 15% of principal are limited to 4.4%.

The product has a return score of 6.93, compared with 5.87 for its peers.

"This score is also unusually higher than average. Reverse convertibles in nature are a very large group of products with a wide range of scores. Some perform very badly; others, such as this one, perform very well. But usually performance is not that great," she said.

"Again, it looks like in this case the market may have been moving in favor of the product.

"The mere fact that implied volatility decreased as it did between the time when the issuer priced it and the time we scored it, more than likely, has helped decrease the riskmap, increase the return score and increase the price score because the value of the options was higher."

Overall score

To wrap up its report, Future Value Consultants generates an overall score. It measures the firm's general opinion on the quality of a deal and is the average of the price score and the return score.

The product has a 7.63 overall score versus 5.88 for the average of its peers.

"The return score is high. The price score is much higher. The result obviously is a very high overall score when compared with the average reverse convertible," she said.

"This product is designed for investors looking for yield, but they do need to have a view on the stock. There is market risk involved with these products, and the investor has to be willing to take the risk of the stock itself.

"The structure changes the risk reward profile of a long position in a stock. Rather than investing in the stock itself, you're accepting a capped return, which is your coupon. You are also reducing the risk as you're getting exposure to the stock with a barrier.

"If an investor is willing to buy the stock, the risk is no less than the outright investment.

"But you can't really buy it and sell it during the term."

The notes are expected to price Thursday and settle Dec. 24.

J.P. Morgan Securities LLC is the agent.

The Cusip number is 48126NL54.

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