JPMorgan’s 7% autocallable yield notes linked to CSX show disappointing risk-adjusted return

By Emma Trincal

New York, June 24 – JPMorgan Chase Financial Co. LLC’s autocallable yield notes due July 6, 2017 linked to the common stock of CSX Corp. are designed for investors seeking fixed interest payments, but there is a price to pay for the benefit of the guaranteed coupon, said Tim Vile, structured products analyst at Future Value Consultants.

“We see fewer single-stock-linked notes with a fixed coupon. Instead people seem to prefer contingency on single names or worst-of based on indices,” he said.

The notes will be guaranteed by JPMorgan Chase & Co., according to a 424B2 filing with the Securities and Exchange Commission.

The interest rate will be at least 7% and will be set at pricing. Interest will be payable monthly.

The notes will be called at par if the stock closes at or above its initial share price on Dec. 30, 2016 or March 30, 2017.

The payout at maturity will be par unless the stock closes below its trigger level, 70% of its initial share price, on any day during the life of the notes and finishes below its initial share price, in which case investors will be fully exposed to the stock’s decline.

American barrier

“It’s difficult to price those products with an attractive coupon. Most of the time, as it is the case here, you have to introduce an American barrier, which makes for a risky proposition,” he said.

The term “American” barrier refers to the fact that the observation date is not on point-to-point but on any trading day during the life of the notes.

“Perhaps investors have shied away from those products because the American barrier adds a great deal of risk, and yet you need it to generate the fixed rate. The coupon is not always spectacular. Seven percent doesn’t seem like a coupon that’s going to knock you down.”

Instead of traditional reverse convertibles, investors have flocked into other types of income-based products in a continued effort to capture yield, he explained. Contingency of the coupon and multiple underlying indexes have been the most common alternatives recently seen in the market.

“When you want a guaranteed coupon, you have to sacrifice a lot in premium. Your coupon is not going to be as high, and your barrier will almost always be based on an American option,” he said.

“Many would prefer to see a coupon that’s a lot higher along with a European barrier even if the rate is not a fixed coupon.”

A European barrier is observed point-to-point, usually at maturity. As a result, it is less risky than an American type of barrier.

Scores

Future Value Consultants produces various scores in order to assess risk, returns and value.

The research methodology generates reports designed to assess the quality of a product compared to the rest of the market. Each product is also compared to its peers under the “same product type” category. In this case, the product type under Future Value Consultants’ methodology is “review reverse convertible,” which designates autocallable notes paying a fixed interest rate.

Riskmap

Future Value Consultants assesses the risk associated with a product by adding two risk components, market risk and credit risk. The resulting riskmap measures risk on a scale of zero to 10 with 10 as the highest level of risk possible.

The market riskmap for the notes is 3.34, compared to an average score of 2.59 for the same product type, according to Future Value Consultants’ research report for this product.

“If you put an American barrier on an asset that has a reasonable amount of volatility, you are going to generate risk, obviously. But it’s usually the way those products are put together. You need the volatility and the American barrier in order to offer the guarantee,” he said.

The implied volatility of CSX, a transportation company, is around 30%.

“It’s not super high but high enough to give you more market risk than average.”

Autocall, entry

One risk-reducing factor common to all products in this category is the automatic call.

“You can get called after six months and nine months. When there is an early redemption, the risk is no longer part of the equation,” he said.

“But in this case you can’t get called for the first six months, which may have limited some of the risk-reducing impact of the feature.”

When making their decision to invest in single-stock-linked notes, investors should be familiar with the name. Examining the price history may influence the decision as well.

Some investors may feel confident about the timing of the trade as the share price is trading close to its 52-week low, he noted.

The stock is down 28% from a year ago.

“If you’re familiar with CSX, if you believe the stock has bottomed out, you may think now is a good time to enter the trade. This note allows you to get some income from this view,” he said.

“Of course, no one can call a bottom, and this is a stock that can move a lot quite rapidly.”

In just two weeks in the early part of May, the share price lost 10%.

The deal is set to price on Thursday. It is possible that the repercussions of the Brexit vote may dampen the share price even further, he said.

Global markets tumbled on Friday after the news that the United Kingdom had voted to leave the European Union.

The S&P 500 index closed down 3% on Friday. The share price for CVX fell 4.60% to $25.78.

Credit

Offsetting some of the negative impact of the higher market riskmap, the report showed a lower level of credit risk. The notes have a credit riskmap of 0.35 versus a 0.47 average score for the category.

“All those products are short-term, so duration is not really a factor here. It’s more issuer-related. JPMorgan is a good credit,” he said.

At 3.69, the riskmap ended up higher than the 3.06 average score but not by a whole lot, he said.

“The credit risk helps a lot. But the risk is elevated, especially when you compare it with the average for all products,” he said.

The “all product type” category includes recently rated notes across all structure types. Their riskmap is 3.13 on average, according to the report.

Return score

Future Value Consultants measures the risk-adjusted return of each product with its return score.

The score is calculated using five key market assumptions: neutral, bullish, bearish, high volatility and low volatility. The best of the five scenarios is selected to measure the risk-adjusted return on a scale of zero to 10.

The assumption used in the model for this product is low volatility.

The 5.93 return score for this product is lower than the average for the same product type, which is 6.42.

“The interest rate caps the upside, and on top of that, 7% is not the most ground-breaking coupon considering that the market riskmap is pretty high,” he said.

Price score

On the other hand, the notes exhibited a relatively better value compared to similar products as suggested by the price score, which measures value on a scale of zero to 10 with 10 as the best possible value.

The notes showed a 5.87 price score versus 5.61 for the average of review reverse convertibles.

“It’s slightly better. They had to spend money on the options to provide a fixed coupon, which is expensive to price. Also this 7% gives you some kind of a buffer,” he said.

Still, Vile said the value score could have been better.

“The American barrier creates a significant amount of risk. It looks like the price score could have been a lot higher with a European barrier, and of course raising the coupon would have made a big difference.”

Overall score

By averaging return score and price score, Future Value Consultants generates its overall score, which represents a general assessment of the product. The notes have a 5.90 overall score compared to 6.01 for the average of the same product type, the report showed.

“The return score holds it back, and the price score is not that good. This is an average product, but there is a demand for guaranteed coupons, and this is what the product is for. Unfortunately, you’re giving up a lot of premium for this guarantee. It looks like the coupon may have been priced a little bit too low. I can’t imagine that 7% would persuade a lot of people to take on that type of risk.”

J.P. Morgan Securities LLC is the agent.

The notes will price on June 30 and settle on July 5.

The Cusip number is 46646EJJ2.

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