JPMorgan’s $3 million barrier digital notes on indexes offer dual directional payout

By Emma Trincal

New York, June 16 – JPMorgan Chase Financial Co. LLC’s $3 million of 0% contingent buffered digital notes due June 16, 2021 linked to the least performing of the Dow Jones industrial average, the Russell 2000 index and the S&P 500 index give investors a wide range of possible excess return between minus 30% and plus 10%.

If losses occur, they will be steep; on the upside, the main risk is to miss the chance of earning more than 10% a year.

Advisers had different views on this product based on their respective market outlook.

If each index finishes at or above 70% of its initial level, the payout at maturity will be par plus the contingent digital return of 10.25%, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will lose 1% for each 1% decline of the worse performing index.

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he liked the notes for a number or reasons.

Correlation

“You’re not going to have big divergences between those three indexes. Maybe between the S&P and the Russell but it’s not much,” he said.

The coefficient of correlation between both large-cap indexes and the Russell 2000 is 0.94.

“It’s a pretty significant correlation. It’s highly unlikely that one of the three indexes would drop more than 30% while the other two would be up.”

Credit, fee

Kalscheur always starts his analysis of a note by reviewing the credit quality of the issuer.

“We have more exposure to this name than to anybody else. We’re at the point where we might need to spread our risk out. But we’re very big fans of JPMorgan.”

The note, which priced on June 10, has a maturity of one year and six days.

“It’s a good thing to have the long-term capital gains,” he said regarding the tax treatment.

The fee is 0.6%, according to the prospectus.

“It’s not a deal-breaker.”

Finally, Kalscheur liked the choices of indexes.

“Clients know what the S&P is, what the Dow is and in most cases what the Russell 2000 is. If the exposure was to some kind of a basket of stocks or sectors we wouldn’t feel as comfortable,” he said.

Deep barrier

But what Kalscheur was most enthusiastic about was the probabilities of getting paid.

“The chances of making 10% in a year are really good,” he said.

The adviser has compiled data on the three underlying indexes going back to different dates – 1950 for the S&P 500 index, 1985 for the Dow Jones industrial average and 1987 for the Russell 2000 index.

Looking at 12-month rolling periods, the chances for the S&P to drop more than 30% are 1.4%, he said.

The frequency is 1.9% on the Dow and 2.3% on the Russell based on their respective historical data.

“You have very low single-digit chances of breaching the 70% barrier and therefore a high probability of getting your 10% after a year.

“That’s pretty compelling.”

The notes generate alpha when the worst-of (net of dividend) falls anywhere between minus 30% and plus 10.25%.

There is approximately a 50% chance of being in that range, said Kalscheur, according to the three statistical series he employed for his back-testing analysis.

“You’re taking a 50/50 chance of getting paid 10%. You could be trailing the market and who knows by how much.

“But it’s essentially a 10% gain or being capped out.

“You still have a 2% chance of losing a large chunk of money. But you’re being compensated at a level that justifies the risk you’re taking on.”

Portfolio allocation

Kalscheur said he could use the notes in his portfolio in two ways – equity replacement but also bond substitute.

“I can see myself using that for equity. The 10% return is high enough to justify taking it out of my equity allocation,” he said.

Kalscheur said he could also use the notes as a bond substitute given his expectation of getting paid.

“Is that as good as Treasury? No, absolutely not. But I’m getting 10%, not 0.18%, which is approximately what you get on a one-year Treasury.

“Since I get a very high chance of getting paid with some risk, I could compare it to a junk bond exposure.

“Don’t get me wrong. It’s not a bond. It has nothing to do with a bond. But when the alternative is getting 0.18% on a Treasury or probably less than 2% on a one-year corporate bond, if that’s what your choices are on the bond side, then maybe it makes sense to consider it as a bond alternative given the high likelihood of getting paid.”

Kalscheur said he valued the fact that the notes could easily fit into a portfolio.

“I can see myself taking it away from an equity allocation just as easily as using it as a high-beta, high-yield complement to a bond allocation,” he said.

Uncertain market

Steven Foldes, vice-chairman of Evensky & Katz / Foldes Financial Wealth Management, said his view on the deal was more “ambivalent” than usual.

Among the positive aspects, he cited the creditworthiness of the issuer. The 0.6% fee was “not so onerous,” he added.

Finally, the worst-of payout was “not a concern,” he noted, because the correlation among the three indexes was “very high.”

His concern was the level of protection in the current pandemic environment as the market is highly sensitive to the development of future Covid-19 treatments.

“We’re still in this health crisis,” he said.

“We’d like to hope that we’ll have some resolution in terms of medical intervention or vaccination within a year. That’s what the market has been pricing and that’s why it has gone up so much.

“If this doesn’t happen, if for instance the vaccine doesn’t provide enough safety, we could have a very big market drop.

“So, for a change, I would prefer a longer maturity, maybe 18 months, so we could have a little bit more time in case medical solutions to this problem takes a little longer to work out.”

Buffer preferred

By the same logic, while the 30% provides a large amount of protection, Foldes said he would prefer a hard protection instead of a barrier.

“I would rather have a buffer. I would be willing to exchange the 30% barrier for a 20% buffer. You’re giving something up, but you get the certainty of a buffer with a guaranteed protection of 20%,” he said.

More return

His final objection was the digital amount itself.

“Net of dividend, you’re not exactly getting 10.25%. it’s more like 8.5% if you take the midpoint.”

He was comparing the dividend yields of the three underlying: 2.3% for the Dow Jones, 1.9% for the S&P 500 and 1.5% for the Russell 2000.

“I’m aware that you can capture this return even if you’re down 30%. But it’s still not very high,” he said.

“If we go for one and a half years instead of one year, we will hope to be able to get more upside.”

Foldes said he prefers to be more defensive considering how much the market has rallied since its bottom in March.

“If we were pricing the deal on March 23, I would have no problem with a 70% barrier.

“But we had such a big run in the past three months, protection is necessary at this point.”

Since the lows of March, the S&P 500 index has gained 42.5%, the Dow, 44.3% and the Russell 2000, more than 50%.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes settled on Monday.

The Cusip is 48132MGJ4.

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