JPMorgan’s reverse convertibles tied to Devon Energy offer oil volatility bet with low barrier

By Emma Trincal

New York, Jan. 9 – JPMorgan Chase & Co.’s upside autocallable reverse exchangeable notes due April 26, 2016 linked to Devon Energy Corp. shares enable investors who believe that oil stocks are near bottom to earn an attractive coupon with a relatively strong level of downside protection as measured by the barrier level, said Tim Vile, structured products analyst at Future Value Consultants.

The coupon will be 8.25% to 10.25%, payable monthly, with the exact rate to be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par if Devon Energy stock closes at or above the initial share price on July 21, 2015, Oct. 21, 2015 or Jan. 21, 2016.

If the notes are not called, the payout at maturity will be par unless Devon Energy stock closes below the buffer level, 65% of the initial level, during the life of the notes and finishes below the initial price, in which case the payout will be a number of Devon Energy shares equal to $1,000 divided by the initial share price.

Bottom-fishing

Future Value Consultants in its research measures risk, return and price using a variety of proprietary scores in order to compare a product with others.

Each product is assessed against two different averages: same-product type and all-products recently rated. In this case, the notes belong to the reverse convertible category.

In order to run the research report, Vile said he used the mid-point value for the coupon at a 9.25% hypothetical rate, which is 11.57% for the 15-month length of the notes.

“The barrier can be breached any time during the 1Ľ year, which increases the risk,” Vile said.

“We’re also talking about a volatile stock with an implied volatility of over 30% versus 18% to 20% for the S&P 500.”

Devon Energy is an oil and gas producer, a sector that has been punished by plummeting oil prices. The stock lost nearly 25% in the past six months.

“While some investors may be inclined to look for bargains in oil stocks, nothing guarantees that the sector will recover within the next 15 months, so obviously anyone buying the notes has to be comfortable with the risk associated with not just the name but with the energy sector as well. The stock has been up and down. It’s quite unpredictable. What characterizes the stock right now is its high volatility,” he said.

Market risk

Despite these risk factors, the market risk for the notes is slightly lower than the average reverse convertible.

“It’s probably due to the depth of the barrier. Reverse convertible deals often have a higher barrier, which protects investors less. A 35% price drop is not impossible given the volatility, but it’s quite substantial, especially when you take into account the extent of this stock price decline,” he said.

“You also have the autocall, which can cut the risk to zero when triggered.”

Market risk is measured by the market riskmap, one of the two components – along with credit riskmap – of the overall riskmap score. All riskmaps are based on the zero to 10 scale, with 10 representing the maximum level of risk. The notes have a 3.14 market riskmap versus an average score of 3.57 for products of the same type.

American barrier

On the other hand, the notes have a higher level of market risk when compared to the market as a whole, he said, based on the research report showing an average 2.79 market riskmap for all structured notes recently scored.

“You’re comparing the product with leveraged notes, which tend to be linked to indexes. Indexes are much less volatile than stocks. That’s one factor behind the gap,” he said.

“On top of that, most leveraged notes either have a buffer or a barrier, and when it’s a barrier, it’s usually a European barrier, not an American barrier like we have here.”

American barriers can be triggered at any time during the life of a note, while European barriers are only observed at maturity.

“There is no question that the American type of barrier, which is common with reverse convertibles, adds more risk,” he said.

“But that’s also how you get such a high coupon over such a short period of time. Nevertheless, when you combine this type of barrier with the volatility of the stock, you get a security that’s not suitable to all investors.

“Investors considering the notes would have to believe in the recovery of the stock. There is no need for the stock to jump in price, but you have to be confident that you’re not catching a falling knife.”

At 0.37, the credit riskmap for the product is above the 0.28 average for the reverse convertible category, probably as a result of the longer-than-average maturity, he said.

“But the difference is not telling us much,” he said.

Overall, the riskmap is lower than average for the product type. The notes have a 3.51 riskmap versus 3.85 for the structure category.

Return score

The risk-adjusted return is measured via the return score. This rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. The best of the five scenarios is selected to measure the risk-adjusted return on a scale of zero to 10.

The notes have a 6.27 return score, compared with an average of 6.13 for its peers.

The return score is “average” for this kind of product and “less than average” when compared to all products, he noted. The average score for all products is 7.46.

“You get this relatively good return score because the coupon is quite high and you have less risk than the average reverse convertible,” he said.

“We use the low-volatility scenario to calculate the return score. Under this assumption, the chances of not breaching the barrier are the highest.

“They compensate you adequately for the risk you’re taking if you compare the score with the average reverse convertible.”

But the notes’ risk-adjusted return does not fare so well when compared against all product types as the broader group includes leveraged notes with high caps or no cap.

“This product is a reverse convertible. It has a fixed coupon that limits your upside by definition, which is one of the reasons why it may score lower,” he said.

Price, overall scores

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10.

“At 6.72, the price score is similar to the 6.42 average for comparable notes, even slightly higher,” he said.

“It could be because the one-and-a-quarter-[year] term is longer than average. Many reverse convertibles have a one-year, six-month [or] sometimes even three-month maturity. The longer the period, the more time you have to spread the fee, which tends to lower the score,” he said.

The overall score measures Future Value Consultants’ general opinion of the quality of a deal. The score is the average of the price score and the return score.

The notes have a 6.50 overall score versus an average of 6.28 for the category type.

“The overall score is above the average for this product type but not by a lot. It reflects the slightly better price score and return score,” he said.

“The notes are designed for investors who expect this stock’s volatility to decrease. They may be moderately bullish. They certainly don’t expect prices to collapse.”

The notes (Cusip: 48127D5P9) will price Jan. 21 and settle Jan. 26.

J.P. Morgan Securities LLC is the agent.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.