Deutsche, Goldman, JPMorgan jump on the S&P MidCap 400 bandwagon with two large deals pricing

By Emma Trincal

New York, Nov. 8 - Three offerings sold by JPMorgan and issued by three different banks are giving investors exposure to the mid cap U.S. equity market, suggesting that the asset class is becoming increasingly popular given the size of two of the three deals.

All notes were linked to the S&P MidCap 400 index. The Nov. 23, 2011 maturity date was identical for the three products.

Two deals were large in size: $107.4 million and $42.5 million for the Deutsche Bank AG, London Branch and Goldman Sachs deals, respectively.

The third one, a $7.59 million deal, was issued by JPMorgan Chase & Co.

Small cap rally

Sources observed that the S&P MidCap 400 index outperformed the S&P 500 to date. The mid cap index rose by 15.5% this year versus 9.6% for the large cap benchmark.

Performance over the past year for the mid cap index was also better with a 23% return versus 14.3% for the S&P 500.

"The MidCap 400 has done well over the last several years, particularly recently compared to the S&P 500. And when it was down in 2008, the losses were on par with the S&P 500 rather than greater," said Donald McCoy, financial adviser at Planners Financial Services.

The S&P 500 ended 2008 down 34%. During the same year, the S&P MidCap 400 index lost 36%.

Commenting on the pricing of the three deals tied to the S&P MidCap 400 index last week, McCoy noted that, "It's a typical return-chasing strategy. The index has done well so it has investors gravitate toward it. People always chase what has done well over the last two or three years."

The bullishness around U.S. mid cap stocks is also part of the larger U.S. equity picture characterized by a rally that began in September, said Peter Rup, chief investment officer with Artemis Wealth Advisors, who is bullish on U.S. equities.

Since Sept. 1, the S&P 500 and the S&P MidCap gained 13.25% and 15.3%, respectively.

"There was a fear of a double dip recession and the market over the past one and a half months has dispelled that impression," said Rup. "The market looks very constructive, and we expect higher prices for U.S. stocks. Now it's a question of how high do we go as opposed to how low do we go."

Two knock-out

Both the Deutsche Bank and the JPMorgan deals are knock-out notes structures with a minimum return offered to investors in the absence of a knock-out event.

The terms are almost identical.

In both deals, if the index falls below 75% of the initial index level during the life of the notes, the payout at maturity will be par plus the index return, which could be positive or negative.

Otherwise, the payout will be par plus the greater of the index return and 4.5%.

The difference lies in the fact that the Deutsche Bank product is capped while the JPMorgan notes are not, according to 424B2 filings with the Securities and Exchange Commission.

With the Deutsche Bank notes, the payout is subject to a maximum return of 20% in either case, whether the index falls below the 75% threshold or not; The JPMorgan structure does not have a cap regardless of the scenario.

The third transaction, brought to market by Goldman Sachs, had a very different structure. The notes were leveraged and buffered. They gave investors par plus double any index gain, subject to a maximum return of 15%.

Investors would receive par if the index fell by 10% or less and would lose 1.1111% for every 1% that it declined beyond 10%.

Capped, not capped

Sources compared the three products. Both knock out deals had a 25% buffer. What surprised some observers was to see that the most successful notes - Deutsche Bank's $107.4 million - were also the capped ones while the non-capped knock-out notes were by far less popular with a $7.59 million size.

"Unless the issuer of the big deal has a better credit rating, I don't really know why investors would have massively bought the capped deal as opposed the uncapped one," said a market participant.

However, the creditworthiness was unlikely to be a factor as Deutsche Bank is rated A+ while JPMorgan's credit rating is AA-.

Downside protection

Sources also compared the levels of downside protection.

"Small cap stocks have rallied a lot, and it makes sense to look for a structured product if you worry about how sustainable this rally is. You want to protect your downside," the market participant said.

"Those three deals all capitalize on the belief that if the market goes down, it won't go down that much. The idea is that it could be trading sideways for a while.

"These deals are for investors worried about a tail event, like a flash crash.

"However the two knock-out structures with 25% give you more protection than the 10% buffer one.

"I think the 25% protection is pretty good. I wouldn't expect the small cap market to drop by 25% in the next year.

"But the 10% buffer would make me a little bit more nervous," he said.

Market view

For McCoy, the Goldman Sachs deal was for more neutral as well as designed for less risk-averse investors.

"In a perfect world, your index is up 7.5% after one year and you maximize your return at 15%. So you're not particularly bullish on this one.

"It's a deal for people who are less concerned about a double-dip recession. You only get 10% protection on the downside and you're going to give up more than 1% for each point of index decline on the downside. You'd have to be more optimistic to take this one. You have 25% protection on the other two.

"At the same time, you're not really getting a whole lot on the upside. It's a two-times index return; yet, you're capped at 15%. With the other two, you get 20% on the upside.

The 20% cap appeared appropriate to Brian Kelly, founder of Kanundrum Capital.

"It sounds reasonable. With the VIX at 20 or less, you would expect your price fluctuation to be limited to that range, so capping those deals at 20% makes sense," he said.

Kelly agreed that Goldman's leveraged buffered notes offering was for less bullish investors.

"The view is: it's going to be OK. It's not going to be great. The market is going to be positive but not terribly positive. You're not going to have any minimum return except getting par back," he said.

"If you're really bullish, you'd take the knock-out notes, the Deutsche Bank first, followed by the JPMorgan," said McCoy.

The market participant said that he would prefer the knock-out deals, not based on a more bullish view but because both offered a greater level of protection.

"I would take the 25% protection first without the cap," he said.

JPMorgan was the placement agent on the three deals.

JPMorgan and Goldman Sachs were both placement agents on the Goldman Sachs offering.

JPMorgan was the sole agent on the other two transactions.

Fees for the Deutsche Bank and the JPMorgan offerings were 1%.

The Goldman Sachs deal had a 1.1% fee.

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