JPMorgan’s $21.9 million absolute return notes provide novel feature with changing exposure

By Emma Trincal

New York, March 29 – JPMorgan’s issuing arm brought to market last week a deal, which captured market participants’ attention not for its size, which was modest, but for its inventiveness.

The notes by default are tied to an equally weighted basket consisting of two indexes. But this exposure changes at maturity if the basket level breaches a barrier threshold, in which case the payout structure becomes a worst-of. In addition, the deal offered absolute return with a lower participation rate than the usual one-to-one on the downside.

JPMorgan Chase Financial Co. LLC priced $21.9 million of 0% capped dual directional contingent buffered return enhanced notes due Sept. 24, 2020 linked to the lesser performing of the Euro Stoxx 50 index and the MSCI EAFE index, according to a 424B2 filing with the Securities and Exchange Commission.

A trigger event occurs if the final level of either index is less than its initial level by more than the contingent buffer amount of 40%.

If a trigger event has not occurred and the final basket level is greater than its initial level, the payout at maturity will be par plus 2.85 times the basket return, subject to a 50% cap.

If a trigger event has not occurred but the final basket level is less than or equal to the initial level, the payout will be par plus 50% times the absolute value of the basket return. The maximum payout in this case is capped at 20%.

If a trigger event has occurred, the payout will be par plus the return of the lesser-performing index. In this case, investors will not benefit from the performance of the basket and, instead, will be fully exposed to the decline of the lesser-performing index.

Worst-of for leverage

“On the way up you have leveraged exposure to the basket up to 50%. On the way down, they give you a lower participation rate of 50% for the absolute return. The underlying is leveraged on the upside and deleveraged on the downside,” an industry source commented.

But the fact that investors, may or may not be exposed to the basket depending on the final basket price at maturity was the most intriguing aspect of the structure, this source said, while still downplaying its novelty.

“The pieces are already there. They’ve just put it together differently,” he said.

“What’s different here is the use of a worst-of to provide leverage instead of a coupon.

Deleveraging

The use of a less-than-100% participation rate on the downside for the absolute return was not unheard of, he noted, although he conceded that this feature was rarely used.

“They had to buy a put spread. There was probably not enough value to give you the upside leverage with a 40% contingent protection over a three-and-a-half year. They had to find the money somewhere.”

The capping at 20% on the downside for the absolute return was simply the result of the exposure limited to 50% over the first 40% range of decline.

The lower participation or “deleveraging” capped the return but enabled the issuer to offer a low barrier, he said.

“As long as you don’t breach, you have the exposure to the basket. When you breach, you’re in trouble since you’re going to lose at least 40% of principal. After 40% down, you’re long the worst index,” he said.

“On the upside it’s 3x; on the downside it’s 50%. It’s a very interesting combination of things.”

Target

One disadvantage was the complexity of the structure, he added.

“If you’re selling to retail investors and this looks like a retail deal, it’s a little bit complicated to explain,” he said.

But when told that the fee on the deal was only 0.175%, he quickly changed its mind.

“It has all the gimmicky attributes of a retail deal. But the cost structure indicates that it’s not a retail deal. More than likely it’s institutional.”

Allocation made easy

The notes offered a big advantage to portfolio allocators, a market participant said, pointing to the reference asset, which by default is a basket but which may change and become a worst-of if the barrier is breached.

“I can’t say I’ve ever seen something like that before. But it’s a nice twist on things,” he said.

“You have the Euro Stoxx 50 and the EAFE, two fairly correlated assets. So that helps reduce the risk.

“But obviously a worst-of can be to your detriment.

“Having it as a basket if the barrier is not breached is a nice twist,” he said.

The Euro Stoxx 50 index tracks the equity performance of the euro zone.

The MSCI EAFE index is the equity benchmark for developed countries excluding in North America. The index has more than 60% of its components in Europe, which is why this market participant stressed the high correlation between the two underliers in the notes.

The lower participation on the downside was also clever, he said.

“Usually an absolute return is one-for-one participation. They wanted almost three times on the upside. To get these, you need to deleverage the downside.”

But his favorite feature was the changing nature of the exposure. By using a basket except in the worst case scenario, the issuer was allowed to pick correlated assets.

“I like it because one of the biggest complaints with worst-of is that you don’t know where to place them in your portfolio,” he said.

An example would be the use of the emerging markets index and a biotechnology stock fund.

“By using it 50/50 for the Euro Stoxx and the EAFE you know where it’s going. The allocation is pretty easy. That’s a good thing for advisers.”

J.P. Morgan Securities LLC was the agent.

The notes, which priced March 21, were guaranteed by JPMorgan Chase & Co.

The Cusip is 46646QX42.

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