JPMorgan's callable notes tied to S&P 500, United States Oil Fund: high yield, worse-off risk

By Emma Trincal

New York, June 8 - JPMorgan Chase & Co.'s upcoming "worse-off" 9% to 10% callable yield notes linked to the S&P 500 index and the United States Oil Fund, LP offer an attractive coupon for a short-term period, but the risks are relatively high, sources said.

The planned offering is a so-called "worse-off" deal because the issuer looks at the worse-performing underlying in order to determine how much principal investors get back at maturity, according to an FWP filing with the Securities and Exchange Commission.

The notes will be due Dec. 16, 2010, according to an FWP filing with the Securities and Exchange Commission.

The notes will carry an annualized coupon of 9% to 10% that will be set at pricing. Interest will be payable monthly.

The notes are callable at par on Sept. 16, 2010.

The payout at maturity will be par unless either of the underlying components falls to or below 70% of its initial level during the life of the notes and the final level of either underlying component is less than its initial level, in which case investors will be exposed to the decline of the worse-performing component.

Two underlyings, two conditions

One positive aspect of the deal is that two conditions need to be met, not just one, in order for the investors to lose some or all of their principal, sources said.

First, the "trigger event" must occur, which means that one of the two underlyings, either the S&P 500 or the exchange-traded fund, must decline by more than 30% during the term of the notes.

The second condition is that one of the two underlyings needs to finish lower in value than its initial level.

If only one of those conditions is met, investors will receive their principal back at maturity, according to illustrative examples in the filing.

Oil bulls and contango

Sources said that market conditions in the oil sector offer enough volatility to encourage investors to place bets on crude oil. To some, the bets should be bullish as they see in the Gulf of Mexico oil spill reasons to be anticipating a decrease in oil supplies should the government impose tighter rules for drilling.

In addition, U.S. crude prices tend to peak in the summer season, sources said.

Howard Simons, president of Rosewood Trading, said that while these bullish views exist in the market, the current disaster presents for now significant risks for the popular oil ETF.

"There is a case for being bullish, but it's not necessarily good for the [United States Oil Fund] short term because it deepens the contango," said Simons.

The United States Oil Fund, which trades under the ticker symbol "USO," invests in oil futures contracts and tracks the spot prices of light, sweet crude oil delivered to Cushing, Okla., as traded on the New York Mercantile Exchange, less the fund's expenses.

Contango describes a carrying charge market, where commodities destined for later delivery are priced higher than commodities delivered earlier.

Rolling a long futures position forward in a contango means incurring an added cost known as a negative rolling yield. Such cost exists because the expiring, near-term delivery is sold at a price that is lower than the purchase price for the deferred contract. As a result, the fund performance is eroded.

"Back-month prices have been rising relative to the front month because people anticipate that the reduced drilling activity will lower supplies," said Simons.

"As the USO rolls month to month, more negative contango makes more negative yield. This places a greater burden on the USO to make money," he said.

S&P, oil correlation

Simons stressed another risk faced by investors in the notes: the correlation between the S&P 500 and the oil ETF is significant, he said.

"The current oil spill also has a negative influence on the S&P as the oil services and drilling sector is being hit very badly," he said.

"Rightly or wrongly, large caps in the U.S. and the spot price of crude oil have been highly correlated in the last couple of years. It gives you double overlap; it increases your risk. That's why they give you a 9% annualized coupon," Simons added.

"If the S&P 500 drops, it's almost a given that the spot price of crude oil will drop. It pushes oil price in deeper contango. And for the note investor, it increases the probability of these trigger events to occur," he said.

Still worth it

In spite of such risks, Simons said that he liked the deal.

"It's not such a bad deal. You're actually given a fairly high probability of getting paid. It's complicated for the investor, but it's not bad. You get the coupon no matter what, and the odds of breaching the 30% barrier are low," he said.

Part of the reason the issuer was able to offer the high coupon, he continued, is because it was able to finance a competitive hedge, with the contribution of the added market volatility.

"I'm sure they're hedging themselves by selling out-of-the-money puts on the S&P 500 with a strike price of 30%," he said.

"For the upside, they're probably selling at-the-money calls with a 9% strike price," he added.

"They invest the two premiums and use it as collateral for the payment."

'Bad outcome mode'

Chris Cordaro, chief operating officer at RegentAtlantic Capital, said that he did not feel comfortable with the notes because of the correlation between the two underlyings and also due to the call risk.

"If one drops, they're pretty tightly correlated, and the likelihood that one will end up lower is fairly significant," said Cordaro.

"By having the worse of the two taken into account for the payout, I'm not sure the structure gives you a lot of extra protection," he added.

"If one of the two breaches the barrier, you're in a bad outcome mode because it's very likely that one will end up lower given how correlated those two underlyings are," he said.

Call scenario

In addition, the notes are callable three months after issuance, which is three months prior to maturity.

"Investors should be willing to assume the risk that the notes may be called and the investors will receive less interest than if the notes were not called," the prospectus warns in its risk section.

If the notes are called after three months, investors will get their principal plus a 2.25% interest payment. This would be the accrued interest up to the call date, assuming an annualized coupon of 9%.

"This call feature adds risk because you have the likelihood that it's going to get called if things go up," said Cordaro.

"So even if you earn the accrued interest after three months, you've taken a significant amount of risk only to earn 2.25%," he added.

The notes will price Friday and settle June 16.

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

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