JPMorgan's $14.18 million capped leveraged floaters on 10-year CMS rate: hedge with high hurdle

By Emma Trincal

New York, July 28 - JPMorgan Chase & Co.'s $14.18 million of capped leveraged floating-rate notes due July 30, 2015 based on the 10-year Constant Maturity Swap rate offer investors who anticipate higher interest rates and inflation a sound way to hedge a bond portfolio, some sources said.

Others noted that the current CMS rate is far below the hurdle, which may put investors at risk of earning only the minimum coupon for five years.

The coupon is 1% plus 4.25 times the 10-year CMS rate minus 500 basis points, up to a maximum rate of 13.75%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive a minimum rate of 1%. Interest is payable annually.

The payout at maturity will be par.

The prospectus explained that the coupon will vary between the 1% minimum and the 13.75% cap. The leverage factor of 4.25 applies to the "spread," or the difference between the CMS rate and the 5% hurdle. It is the spread that will determine the amount of interest investors will receive.

The principal-protected notes are designed for investors who anticipate that the CMS rate will exceed 5%, the prospectus said. If it does not, investors only receive the 1% minimum.

The 5% is the equivalent of a "hurdle" or minimum level above which the investor only begins to earn more than the minimum rate of 1%.

Great for hawks

"The CMS will exceed 5% without a doubt," said Greg Salvaggio, senior vice president of capital markets at Tempus Consulting. "If you're an inflation hawk, it's a great product. It's a portfolio hedge if you're long bonds because your bond value is going to decline if inflation kicks up."

Salvaggio said that rates will go up because "the monetary stimulus can't stay on forever" and "the Fed will have to raise rates, otherwise we will end up like Japan."

He said that despite deflation fears, policymakers and economists are beginning to understand that the zero-interest-rates policy when conducted for too long may actually jeopardize the chances of a recovery.

"Right now, every financial institution, every corporation is hoarding cash. Capital is being put on balance sheets and rolled forward. People are aware that current interest rates are abnormally skewed and do not reflect reality. The monetary stimulus needs to be removed so the economy can stabilize, and I think the Fed is aware of that," he said.

Salvaggio said that the "kicker" in the deal is the 4.25 leverage factor, allowing investors to "start to yield value" once the CMS rate goes above the 5% hurdle.

"For every basis point above that, you're earning 4.25 basis points of yield," he said.

Far out of the money

But others said that the current CMS rate of 3% was low compared to the 5% hurdle, putting investors at risk of not being able to enjoy the benefits of leverage.

Michael Iver, former structurer at JPMorgan, said that investors needed to ask themselves three questions: "First, what is the value of the leveraged spread today? Second, when does one hit the cap? And finally, what can an investor earn alternatively with a five-year Chase deposit?"

Regarding the spread value, Iver said that the current CMS rate would have to increase by nearly 200 bps to 5% before the investor begins to earn more than the minimum 1% coupon.

"That's a rise of the current rate by two-thirds. That's a lot," he said.

Secondly, Iver calculated that investors would hit the 13.75% cap if the CMS rate hit 8%, an increase of 500 bps above the current level.

CD alternative

More troubling was the comparative analysis between the notes and a 2.25% five-year Chase certificate of deposit.

Iver calculated that the CMS rate would have to rise to 5.29% in order for the notes to earn the equivalent of the CD.

"The investor needs the CMS rate to increase from 3.04% to 5.29% in order to earn the CD coupon of 2.25%," Iver said. "The 2.25% Chase CD looks pretty good to me."

"In short, the investor doesn't get anything above 1% until the CMS rate rises above the 5% hurdle. And they don't hit the cap until the CMS goes up above 8%. In addition, the investor has to believe that the current 3% CMS rate has to go above 5.29% in order to earn the current CD rate of the same issuer," Iver said.

"I think the math says it all."

J.P. Morgan Securities Inc. is the agent.

Fees are 0.5%.

© 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.