JPMorgan’s buffered return enhanced notes tied to Euro Stoxx offer no-cap/long tenor trade-off

By Emma Trincal

New York, May 22 – JPMorgan Chase Financial Co. LLC’s 0% uncapped contingent buffered return enhanced notes due May 31, 2023 linked to the Euro Stoxx 50 index are one of the rare leveraged notes that do not cap investors’ gains while providing some protection. But the issuer had to extend the term and use a high-paying dividend in order to be able to price the deal, making the product attractive for some but not for others.

The notes will be guaranteed by JPMorgan Chase & Co.

If the final index level is greater than the initial index level, the payout at maturity will be par plus at least 2.16 times the index return. The exact upside leverage factor will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by 35% or less and will be fully exposed to any losses if the index falls by more than 35%.

Core holding

For Carl Kunhardt, wealth adviser at Quest Capital Management, the product and the underlying offer good value. As a result, the long duration is not a problem.

“It’s not a bad note. I kind of like it,” he said.

Defining himself as an asset allocator investing for the long term, he said European equity will always be a core holding in his portfolio.

“Any portfolio needs an international equity allocation, and if you’re going to own foreign stocks, most of it is going to be Europe. There’s no way around that if you want a diversified portfolio,” he said.

“That’s why the term of the note is not relevant to me.

“If I’m going to own the same 50 stocks six years from now, I am not concerned about the timeframe.”

Parameters

Kunhardt said he also likes the structure: “The barrier is attractive. There is no cap.”

Finally, the underlying offers an attractive prospect.

“If you want to buy low and sell high, the Euro Stoxx is a good place to be in right now,” he said.

Advisers have noticed this year the rebound of European equities. Having underperformed the S&P 500 in the past four years as well as in 2008, 2010 and 2011, the Euro Stoxx 50 is now on a strong bullish track, up nearly 19% this year versus less than 7% for the U.S. large-cap benchmark.

“The parameters are working well and the timing too. It’s a core holding, and it’s a good time to buy,” he said.

Fee

Kunhardt said the cost of the deal is modest.

The fee is 3.5%, which is about 58 basis points per annum, according to the prospectus.

“We’re almost in ETF territory. Can you find an ETF that’s cheaper?”

The answer is “yes,” but the notes offer special benefits one cannot find in an exchange-traded fund such as asymmetrical leverage and a barrier, he added.

“It’s very reasonable, especially for international stocks.”

The SPDR Euro Stoxx 50 ETF has an expense ratio of 29 bps.

“Sixty basis points for a structured note like this one is not onerous.”

Trade-off

The long holding period and the cost of the notes are not an issue for Kunhardt, but the unpaid dividends on a high-yielding index require more explaining.

The Euro Stoxx 50 dividend yields 3%.

“It’s a pretty big dividend, but it doesn’t surprise me. If you look at foreign stocks, a greater part of their total return comes from dividends rather than price as opposed to U.S. stocks,” he said.

“In the U.S., especially over the past 30 years, most of the total return is now coming from capital appreciation rather than dividend growth.

“So the loss of dividend is going to have a higher impact when you buy non-U.S. stocks no matter what.

“That said, this note offers a number of benefits that by far I think compensate you for foregoing the dividends.”

He pointed to the absence of a cap, the two-times leverage and a deep barrier.

“I think for what you’re getting, it’s not a bad trade-off.”

Some good points

Steven Foldes, vice chairman at Evensky & Katz/Foldes Financial Wealth Management, agreed that the notes offer attractive elements but said he would not invest in them.

The creditworthiness of the issuer is one of the positive aspects of the deal. Valuations on European stocks also present a compelling story.

“The European market has certainly been somewhat depressed, so there is an expectation that given its valuation, over the next business cycle we’ll have a reversion to the mean and that the lower value will pay patient investors a nice return,” he said.

Having no cap and double the upside are “always good things,” he said.

“There are a lot of nice features in the notes. Still, it’s not something we would be investing in.”

Too long

The tenor of the notes, which increase the opportunity cost associated with unpaid dividends, is his first concern.

“Six years is a very long time. During that time you’re giving [up] over 20% in dividends. You’re getting two times, but at the same time you’re giving up a significant dividend opportunity,” he said.

But the size of the barrier is perhaps the major flaw. He wished more money would have been allocated elsewhere, in particular to the upside.

Misallocation

“The idea of paying for a 35% barrier over six years to me doesn’t seem like a good investment,” he said.

“The likelihood of a major asset class like Europe to breach that barrier after a six-year period is very low.”

One would have to do the backtesting, he noted, but his “guess” is that the review of six-year trailing periods going back several decades in time would suggest how unlikely the “breach” outcome would be.

“I’d rather pay for a shorter note and higher leverage,” he said.

Capping

Foldes said he knows that shortening the term while adding more leverage could not be done without including a cap.

“We realize that uncapped notes have become very rare because it’s expensive. That’s why they had to price this one over six years,” he said.

Foldes said he is not opposed to caps, but the height of the cap counts.

“The caps have come way down. I can live with 60% cap on a two-year note. It’s not the uncapping that matters. It’s what the cap is going to be.

“We realize the uncapping would be impossible with a shorter-term note, but giving up 20% over six years is not inconsequential.

“The 35% barrier we think is expensive and not terribly necessary.”

Based on that, Foldes said he would negotiate for a shorter-dated product with “some amount of leverage and some amount of buffer,” adding that the cap would have to be “a cap we think we can live with.”

J.P. Morgan Securities LLC is the agent.

The notes will price on May 25 and settle on May 31.The Cusip number is 46647MCU5.

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