JPMorgan's Joy Global reverse convertibles need more coupon given risk, analyst says

By Emma Trincal

New York, Dec. 7 - JPMorgan Chase & Co.'s 10.25% reverse convertible notes due March 15, 2013 linked to Joy Global Inc. shares warranted a higher coupon based on the product's riskiness, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par in cash unless Joy Global shares fall below 80% of the initial price during the life of the notes and finish below the initial price, in which case the payout will be a number of Joy Global shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

Short-term investment

Just because the product is a short-term investment with a barrier on the downside does not mean it is not risky, said Hampson.

The key factor in the notes' risk, she said, is the volatility of the stock, adding that Joy Global's one-year implied volatility is 45%.

"It's high, but we've seen higher, sometimes up to 80% with 25% coupons. So it's not at the highest end of the spectrum. However, it's a lot higher than the S&P or the iShares that issuers use quite often," she said.

The very short tenor can contribute to losses if the barrier is breached, she said.

"We're looking at a short-term investment. If you're a long-term buy-and-hold investor, obviously, this is not for you," she said.

"You're either going to breach the 80% barrier and have a very limited chance of recovering 20% in three-months or you'll receive your full investment back. In that case, you will have earned 2.5% in three months, which is much higher than the risk-free rate. That's what investors are looking for," she said.

Riskmap

Future Value Consultants measures the risk associated with a product as its riskmap on a scale of zero to 10. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

At 6.05, this product's riskmap is much greater than the average for the same product at 4.07.

"It's all market risk. We have a pretty volatile stock with the potential to fluctuate and generate downside losses," she said.

At 5.80, the market riskmap of the notes is greater than 3.48 for the average in the reverse convertible structure type.

"An 80% barrier seems quite generous compared to other products. But given the volatility of this particular stock, the odds of breaching the barrier are not negligible.

"The above-average riskmap is also the result of the short life of the product, which doesn't give you much time to make up for losses if the stock is down by more than 20% at some point during the three-month term."

The credit riskmap, which measures the risk of not getting interest payments during the term and principal back at maturity is not a real factor here given the short life of the product, she noted.

"Investors in reverse convertibles seek a higher fixed rate of income and are willing to take on market risk exposure to achieve that goal," she said.

"It's similar to a put sale. It's a simple structure for investors to get their arms around. It is very stock-dependent, underlying-dependent."

Not equity, not bond

But the payout differs from a direct equity exposure, as investors do not participate in the stock performance, she said.

"It's not like being long the stock. Rather, you are short volatility, hoping to get a higher than average rate of return if the stock remains stable, while taking away some of the risk. The key is not to breach the barrier, just like a put seller would bet on the stock remaining above the strike," she said.

Investors are not going to get paid more than the coupon. As a result, the product is not appropriate as a strongly bullish trade, especially for those who expect a sharp price increase above the coupon, she said.

"It's a bullish product but you shouldn't be too bullish otherwise you would be better off with the stock itself or a note that offers participation in the upside," she said.

"It's not a growth strategy because your income is not dependent on the performance of the stock. Instead, this is a short-term income strategy for people who are looking for yield in this low interest rates environment."

"So while you get exposure to a single stock, this is not a substitute for a long-term bullish play on that stock.

Just like fixed-income investors, buyers of the notes seek a coupon-bearing instrument, she said.

"In both cases, you get a predictable income.

"But it's a different proposition than a safe fixed-income investment because you have some market risk exposure. You get the attractive coupon precisely by being willing to take on some risk in exchange."

This is why investors should pay attention to the risk-reward trade-off associated with the product and reverse convertibles in general, she said. The greater the risk, the more reward investors should expect.

Risk-reward

Future Value Consultants measures the risk-adjusted return with its return score on a scale of zero to 10. The score is calculated from five key scenarios - neutral assumption, high and low growth environments, and high and low volatility environments. FVC calculates a risk-adjusted average return for each assumption. The return score is the best of these five returns.

With reverse convertibles, the optimal scenario is low volatility as investors expect the barrier to be untouched in order to achieve the maximum return.

Investors in the product have a 25.2% chance of losing more than 15% per annum under the neutral assumption, which is a risk-free growth scenario.

However, under the best "low volatility" assumption, that probability is reduced to 21.4%.

The return score shown for this product is disappointing, according to Hampson.

At 5.47 the return score for the notes is "way below" 6.20, which is the score for reverse convertibles in general.

"The return score represents the potential return given the amount of risk you're taking on," she said.

"Since it's already quite a high-risk product, the issuer has to offer a very high return to compensate for that amount of risk.

"It looks like investors should have been rewarded with more than 10.25% and that's why the returns score is below average," she said.

Price, overall

Future Value measures a note's value to the investor on a scale of zero to 10 via its price score. 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. The average price score for this product is 6.90 while it is only 4.61 for this product.

"It's considerably below average," she said.

"This product is priced very low, which indicates that not enough fixed-income is paid to offset the risk. These are still indicative terms. The coupon could increase on the pricing date, although it's rare to see last-minute changes when the terms in the prospectus are fixed as they are here, as opposed to defined in a range," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

The notes have a 5.04 overall score versus 6.55 for the average of the same product type.

The notes are expected to price on Wednesday and settle on Dec. 17.

JPMorgan is the agent.

The Cusip number is 48126DNQ8.

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