JPMorgan's reverse exchangeables linked to Gilead show below-average value due to margins

By Emma Trincal

New York, March 28 - JPMorgan Chase & Co.'s 9.5% to 11.5% upside autocallable reverse exchangeable notes due April 9, 2015 linked to the common stock of Gilead Sciences, Inc. involve hedging costs that the issuer partly passes on to the investor, leading to a product with less value than average, said Tim Mortimer, managing director at Future Value Consultants.

"This note shows lower scores, which is partly due to the way we evaluate volatility, taking into account the margins banks need to set aside to cover the risk of hedging this trade," Mortimer said.

The notes will be automatically called at par if Gilead Sciences stock closes at or above the initial share price on July 3, Oct. 3, 2014 or Jan. 5, 2015, according to an FWP filing with the Securities and Exchange Commission.

Interest is payable monthly.

The payout at maturity will be par unless Gilead Sciences shares decline by more than 25% during the life of the notes and the final share price is less than the initial share price, in which case the payout will be a number of Gilead Sciences shares equal to $1,000 divided by the initial share price or, at JPMorgan's option, a cash amount equal to the value of those shares.

Volatility estimate

The notes are reverse convertibles: they offer a fixed interest rate, but capital is at risk, Mortimer said. Investors lose the benefit of the downside protection if the stock breaches the barrier on any trading day, a type of barrier known as an American option.

The combination of a reverse convertible with an autocall provision fits into the "review reverse convertible" category, according to Future Value Consultants' methodology.

As with most reverse convertibles, the notes are linked to a single stock. The higher volatility associated with stocks, but most importantly the fact that the underlying options are less liquid, will have a great impact on the pricing score and the return score, he said.

"The volatility estimate in single-stock deals is quite important because it's the basis for the pricing of the options, and single-stock options tend to be less liquid than equity index options," he said.

"Spread levels between bid and offer or bid and midpoint are wider. It's pretty standard for single stocks.

"Banks have to take more risk given that the options are less liquid, and usually they take a margin for that.

"When we estimate the volatility, we take the midpoint to run our scoring. We're trying to incorporate in our analysis the difference between the fair market value and the price at which the bank is prepared to buy the call. The fact that they are calls makes it even more risky for the bank."

Marking down

In a reverse convertible, the bank is long a call and sells it to the investor to generate the coupon.

"Banks have to make a judgment on how much premium they're willing to pay and how much they're willing to give back to the investor," he said.

"Banks will mark the volatility lower in order to get the margin they need to cover the risk. We typically estimate volatility at a higher level than what the banks do as they base their valuation on the need to cover the liquidity risk involved with the trade.

"This is why when you compare a reverse convertible with an index-linked note, typically the value score of the reverse convertible, what we call the price score, is going to be less."

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

High margin trades

Another important score developed by the research firm is the return score. It measures on a scale of zero to one the risk-adjusted return under the best market assumption.

"Reverse convertibles are high margin trades. Banks need to calculate how much premium they're willing to pay. Investors need to know that they will incur higher fees," he said.

"This is why it's important for investors to get their market view right and to pick the right stock if they want to cover the cost of the transaction and do more than just break even.

"Those reverse convertibles pay a higher coupon than anything based on the S&P 500. But the question is always whether it's high enough to justify the risk.

"The investor is by nature an income-seeker, but he also has to have the profile of a trader. A lot of the success in a reverse convertible trade depends on timing. The investor has to choose which stock, when and how much risk to take. He needs to bet on volatility moves going forward."

Riskmap

Investors in reverse convertibles make money if the barrier never gets breached. Assessing the risk level will also depend on volatility as it directly impacts the probability of breaching the barrier, Mortimer explained.

Future Value Consultants measures the risk associated with a product with its riskmap on a scale of zero to 10, with 10 as the highest level of risk possible.

The riskmap is the sum of two risk components: market risk and credit risk.

Impact of volatility

The market riskmap is 4.72, compared with an average score of 2.83 for the review reverse convertible category and 2.99 for all products, according to the research report produced by Future Value Consultants.

In its scoring, the firm compares a product with its peers (same product type) as well as with the "all products" group, which represents notes that have recently been rated across all structure types.

"It's when we assess the volatility a bit higher that you get that greater market riskmap," Mortimer said.

"Also you have a 75% American barrier. That's not very much. If the notes aren't called, by definition, it means that the stock has been below 100 three times. The distribution where you expect to be at maturity is significantly below 100 as well."

The credit riskmap is just average at 0.28. The average for products of the same type is 0.29, the report showed.

Due to the greater level of market risk, the product's riskmap, 4.99, is higher than the 3.12 average riskmap seen for this product type. It is also greater than the general average riskmap of 3.49.

Poor risk reward

The 5.65 return score associated with the notes was disappointing when compared to the peer group average of 6.37, he said.

"Our higher estimate of the volatility is driving this score as well because the coupon doesn't quite compensate for the risk taken," he said.

"The bank marks the premium they buy at a lower level than its fair market level. They do that to cover the risk, but by the same token they offer a lower coupon."

Low price, overall scores

The gap in price score, also a result of the volatility valuation, was even greater. The notes received a meager 5.23 price score, compared with the 7.01 average for this product type.

The final and most important rating developed by Future Value Consultants is the overall score. It offers a general opinion on the quality of a deal based on the average of the price score and the return score.

At 5.44, the overall score for the notes is much below the average of its peers, which is 6.69.

Mortimer drew some conclusions about how investors should conduct their due diligence when trying to filter reverse convertible candidates.

Due diligence

"With reverse convertibles, it's critical to have a very strong view of the stock you're investing in. Part of the investor's job is to have a view on the implied volatility. These trades are very different than anything linked to the S&P where you can get the exposure to the benchmark at a much lower cost," he said.

"At the contrary, with a reverse convertible, the premium you pay the bank to conduct the trade represents a higher fee, so you really need to know your stock quite well. You pick the stocks that make sense and then you judge if the yield is worthwhile. There is no point in doing this the other way around by chasing the yield first. That's the wrong approach.

"Do your research on the stock, look at the maturity and the nature of the barrier. The coupon should not be the main driver of your selection."

The notes (Cusip: 48127DCQ9) are expected to price April 3 and settle April 8.

J.P. Morgan Securities LLC is the agent.

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