JPMorgan’s worst-of notes on Russell, Euro Stoxx offer bull play with no cap, 2.25 x leverage

By Emma Trincal

New York, Jan. 26 – JPMorgan Chase Financial Co. LLC’s 0% uncapped contingent buffered return enhanced notes due Jan. 31, 2023 linked to the least performing of the Russell 2000 index and the Euro Stoxx 50 index give investors an opportunity to outperform the market in a bullish environment, said Suzi Hampson, structured notes analyst at Future Value Consultants.

Applying the worst-of payout to a leveraged structure, a technique seldom used, JPMorgan is able to boost leverage, eliminate the cap and provide a deep barrier, three features that would not be easily replicable if the leveraged notes were tied to only one of those two assets, she noted.

If each index finishes at or above its initial level, the payout at maturity will be par plus at least 2.25 times any gain of the lesser-performing index, according to a 424B2 filing with the Securities and Exchange Commission.

The exact participation rate will be set at pricing.

If either index return is less than its initial level, but finishes above the buffer level of 50% of its initial level, the payout will be par.

Otherwise, investors will lose 1% for each 1% decline of the lesser-performing index from its initial level.

Worst-of plus leverage

“We’re so used to having worst-of in a kick out scenario,” she said referring to autocallable notes.

“With a leveraged product, it’s quite different. We know it’s going to be exactly five years. What we don’t know in advance is which index will be the worst.”

Adding a second underlying is what allows the issuer to bring together a combination of attractive terms because it increases the chances of hitting the barrier, she said.

“The leverage is quite high; the 50% barrier is pretty deep. Also you don’t have a cap,” she said.

These terms are appealing to bullish investors. But since worst-of are not as frequently used in leveraged notes than they are in autocallables, buyers of these products should be aware of the risk, which rises inversely to the correlation.

“Those two indices with a 0.73 correlation are not completely uncorrelated. Still you always have the risk to see one of them lagging or taking the opposite direction,” she said.

“Having a worst-of in your portfolio is something a little bit more complicated to get your head around. You are only concentrating on the worst-of. That’s the performance you’re tracking. It’s going to be a little bit more difficult to monitor that type of risk in your portfolio.

“But that’s the trade off.”

Three outcomes

Future Value Consultants offers stress testing on structured notes showing probabilities of return outcomes for each specific product and product type.

Each report contains a total of 29 sections or tests, comprised of simulation as well as back testing analyses.

The simulations are arranged around four market scenarios, which correspond to different growth rate assumptions for each underlying. The market scenarios are bull, bear, less volatile and more volatile. A neutral scenario is the basis of the simulation in all reports reflecting standard pricing based on the risk-free rate, dividends and volatility of the underlying.

Hampson analyzed the three potential outcomes for this product using one of the report’s tables called capital performance tests. The notes can either return more than capital, return exactly capital or return less than capital, according to this test.

No pain, no gain

There is a 32% chance to get a positive return under the neutral scenario versus a 50% probability of getting exactly capital (no losses, no gains) when the worst index drops less than 50% at maturity.

In comparison the chances of losing money in this neutral scenario are slim. The probability for that is 18%.

The product carries two different types of risks, she explained.

“There is the probability of breaching the barrier, which is 18%. And there is the opportunity cost scenario, which is significantly more likely as it will happen half of the time under the neutral scenario. That’s not such a great outcome. Your capital has been invested five years without yielding any positive return. This is the biggest risk of this product,” she said.

Barrier

A 50% probability of seeing the worst-of ending between 50% and 100% is “quite high,” she said.

She offered an explanation.

The most obvious one is simply the low level of the barrier, allowing the worst-performing index to drop as much as half of its initial price.

“It’s a greater range of possibilities when you compare that with a traditional 15% or 20% protection,” she said.

Another important factor, she explained, was related to the firm’s conservative methodology when determining hypothetical growth scenarios of the underlying for its Monte Carlo simulation.

If the neutral scenario shows a 50% chance of getting the “return exactly capital” outcome, the bull scenario sees this probability drop to 34%.

At the same time, while investors only have a 32% chance of making money in the neutral scenario, their chance increases to 61% in the bull scenario.

The “return less than capital” bucket is set to happen 5% of the time instead of 18% in the neutral scenario, according to the test.

“There is still a high probability of incurring this opportunity cost in the bull scenario. But at least your chances of making money are much higher and the probabilities of losses much lower,” she said.

Growth assumptions

Part of the explanation regarding the weak results observed in the neutral environment is the negative growth rate generated by the model for the Euro Stoxx 50 index.

As interest rates are negative in Europe and dividend yields higher than in the United States, the forward for this index is negative, leading to a negative growth rate of minus 2.5% in the model, she explained. In the bull scenario, the assumed growth rate is 3.8% per annum.

What appears as a relatively low growth rate in the bull scenario is also a result of Future Value Consultants’ methodology.

In both the bull and bear assumptions, Future Value Consultants does not use extreme performance rates. The bear scenario for instance shows a return rate of minus 8.8% for the Euro Stoxx and minus 4.9% for the Russell 2000.

“We’re not making any assumption of strong growth or strong corrections in our simulation. We’re not predicting the market. We prefer to make reasonable assumptions, which are not unrealistic,” Hampson said.

Payoffs

The capital performance test also displays average payoffs for each outcome and across the five different market scenarios, including the neutral one.

Not surprisingly the breach of a 50% barrier has a painful impact generating an average loss of 65% in the neutral scenario and not much less (62%) in the bull scenario. The bear causes the average loss to rise to 70%, according to the table.

“Anytime you have a low barrier obviously it’s always going to be big losses,” she said.

Some investors find some comfort in the idea that correlations increase in a down market, which reduce some of the worst-of risk. But if correlations rise during a pullback, the market risk can start taking precedence and the outcome can simply be the two indexes crashing.

Looking at the positive outcomes, the neutral scenario generates 56.5% return over the period versus 95.7% for the bull market.

“When the market is up, you’re going to outperform the worst-of. It doesn’t mean you’ll outperform the other index. But the average payoff offers a pretty good return,” she said.

“By introducing a second asset and having the return linked to the worst of the two, the issuer is able to generate a bullish note that can perform quite well in a rising market because of the gearing and because of the unlimited upside,” she said.

“Investors just need to be aware of the risk associated with low correlation.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48129HWP8) will settle on Jan. 31.

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