JPMorgan's single review notes on S&P 500, Russell 2000 lack attractive protection

By Emma Trincal

New York, Jan. 17 - JPMorgan Chase & Co.'s 0% single review notes due Jan. 28, 2013 linked to the lesser performing of the S&P 500 index and the Russell 2000 index are designed to help investors outperform the markets if equity returns remain flat or even slightly down over the next 12 months. Sources, however, said that the product was too risky because in the absence of a payout, investors would lose at least 30% of their principal, making the investment unsuitable for the conservative investor.

"I don't like the loss of control you get with this product," said Carl Kunhardt, wealth advisor at Quest Capital Management.

"While it's fairly straightforward, it's also complex. It doesn't make for an easy meeting with the client.

"I really prefer notes that have a buffer in general, and you don't have it here."

The notes will be called at par plus a premium of 8% to 9% if each index closes at or above 70% of its initial level on Jan. 22, 2013, according to an FWP with the Securities and Exchange Commission.

The exact call premium will be set at pricing.

If the notes are not called, the payout at maturity will be par plus the return of the lesser performing index. Investors will be fully exposed to losses.

For flat market

"If you lose, you lose at least 30% of your money. There is no downside protection. Not that it's a bad note, but it wouldn't fit into any of my clients' portfolios," said Kunhardt.

The structure offers an "either-or" type of payout, said Kunhardt.

"You either get the 8% to 9% call premium or you don't. If you don't, you're guaranteed to lose at least 30% of your investment," he said.

"If you have the conviction that the market is going to be flat or slightly positive this year, then it's a good deal.

"It would have made sense last year given the flat equity returns. The notes would have outperformed the market," he said.

In 2011, the Russell 2000 recorded a 4.18% loss and the S&P 500 gained only 2.11%, he noted.

"But if you're outlook is very bearish, you're not going to touch the thing.

"And if you're very bullish, you wouldn't want it either because of the limited upside.

"I think I would simply prefer to buy the indexes because I wouldn't have to deal with the liquidity risk. If you're in this note, you're in for one year. When you own the index or a fund, you can get out anytime you want. And while I'm not advocating timing the market, when things get really bad, like in 2008, I'm going to cut my losses and sell," he added.

Lee Kramer, president of Capital Management Analytics, shared Kunhardt's view about the soundness of the strategy itself, which is to provide a solid income to investors even if the market is flat or slightly bearish.

But he said that he did not like the risk-return of the trade itself. Instead he would replicate the trade using options with the intent of replacing the 70% barrier, which he called a 30% "soft buffer" by a 30% "hard buffer."

Rich premium

Kramer suggested to sell out-of-the-money puts on the Russell 2000 exchange-trade fund - the iShares Russell 2000 index listed under the ticker symbol "IWM" - as a way to collect a premium. The other "leg" of the trade was to buy a one-year obligation of JPMorgan Chase & Co. on the secondary market as the necessary collateral to secure the puts.

He chose to sell the puts on the most volatile of the two underlying indexes - the Russell 2000 - in order to optimize the put premium to be received.

"The options are very expensive on these far-out-of-the-money puts that are way out, mainly because people want insurance. You're handsomely rewarded if you sell those puts," Kramer said.

The puts were said to be "far out of the money" because the strike price of 70% is seen as substantially less than the original price.

From soft to hard

"Right now, the IWM is at $76.83. If you sell a put with a strike price of $55, which is approximately 30% below the current price out of January 2013, you're collecting a 5.5% premium.

"Then you buy a one-year JP Morgan note on the secondary market and you can collect a 2.8% yield.

"By selling out-of-the-money puts on the IWM and using the one-year JP Morgan Chase debt as collateral, you recreate a yield of around 8.3%.

"Note that this 8.3% return is a given. Once you've invested your capital in the JP Morgan bond and collected your premium, you get this no matter what. Your income is not contingent upon anything else as it is the case with the call premium paid on the structured note.

"You have the same amount of principal tied up with the same credit risk and a comparable return.

"The big difference is that you no longer have a soft buffer as you did with the notes. You now have approximately a 30% hard buffer from the starting point. On top of that, you have your 8.3% return from the bond yield and option premium acting as an additional cushion," Kramer said.

Kramer went on to explain how the options trade strengthened the downside protection.

"When you sell puts 30% out of the money on the Russell, it means that you're liable to buy the security at a price of 30% below what it is today.

"If in a year the Russell is down 40% from what it is today and you are forced to take delivery at a price 30% lower than today, you would only be on the hook for 10%. Subtract from that the 8.3% income you're getting and you're really on the hook for 1.7% only.

"So instead of losing 40% as you would if you held the notes, your loss from my trade would only be 1.7%. Not only you're changing the strike price as you're no longer subject to all the losses from the initial price, but you're getting much more than just 30% in downside protection. It's a much better deal," he said.

He offered an example incorporating the put sale and the secondary market bond purchase.

According to an illustration in the prospectus showing the returns based on the depreciation of the lesser performing index, a decline of 30% would generate a positive return of 8% while a drop of 30.01% of the lesser performing index would cause a 30.01% loss of capital.

"At a minus 30.01% return for the lesser-performing index, the note would have a negative 30.01% return. My option strategy would reduce this 30.01% loss into a 1 basis point loss, but that's not all. Since I'm collecting 8.3% worth of income from the combined put sale premium and interest generated from the secondary market bond that was purchased, my net return is in fact 8.29%. That's much, much better."

Sleeping at night

Kramer noted that there was a 10.7% probability for the Russell 2000 to drop by more than 30% a year from now, according to what the options market is pricing right now.

The probability for the same outcome applied to the S&P 500 was 3.5%.

"Because the two benchmarks are highly correlated, if you invest in the notes, you have one in seven chances of losing 30% of your capital or more," he said.

"For someone who can afford it, it's not a terrible risk.

"But for a conservative investor, it may not make sense because there is still a chance that 2012 could be a bad year.

"Instead, you can create your own structure with the same amount of capital and for an equivalent return. And you've made yourself immune from the first 30% decline and even more given the income you're getting from the bonds and the option premium.

"Retail investors can create on their own these types of income-producing strategies designed to work even when the market is doing poorly.

"It's much more conservative and you can sleep at night more easily," he said.

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48125VJM3) will settle on Friday.

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