JPMorgan's notes linked to MSCI EM, Russell 2000 seen as alternative to reverse convertibles

By Emma Trincal

New York, July 13 - Using a complex structure, JPMorgan Chase & Co. attempts to offer a competitive one-year income-paying product without using a single stock as the underlying asset, said Suzi Hampson, structured products analyst at Future Value Consultants.

JPMorgan plans to price 7% to 7.5% autocallable yield notes due July 25, 2013 linked to the iShares MSCI Emerging Markets index fund and the Russell 2000 index.

The notes introduce more layers of risk than those inherent to similar products, such as reverse convertibles and autocallables, she noted. But the idea is to offer a decent income in a different format and based on a type of asset other than a stock, she said.

The exact interest rate will be set at pricing. Interest will be payable monthly, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called automatically at par if both underlying components close at or above their initial levels on Oct. 22, 2013, Jan. 22, 2013 or April 22, 2013.

A trigger event will occur if either underlying component falls by more than 40% during the life of the notes.

The payout at maturity will be par unless either underlying component finishes below its initial level and a trigger event has occurred, in which case investors will lose 1% for every 1% that the worst-performing underlying component declines below its initial level.

Complexity

"This is a complex structure. It's a complete hybrid between a reverse convertible and an autocallable. It has benefits and disadvantages of both," Hampson said.

The common feature with the reverse convertible is the fixed interest rate.

"That's one of the good points: you get 7% to 7.5% regardless of the performance," she said.

At the same time, a call can be triggered on a quarterly observation basis, which makes the structure look like an autocallable.

"I'm not sure there's an advantage of being called early with this one because unlike the autocall, you will get your coupon whether you're kicked out or not. An autocall investor almost wants to be called. I guess they did that to enhance the coupon," she said.

"But it's a mix of the two structures. In the same way as a reverse convertible, you have a fixed interest rate. And you have the potential for an early redemption and some uncertainty around the duration of your investment, as it is the case with an autocallable."

But the hybrid nature of the structure and the worst-of feature - the determination of the final payout is based on the worst-performing component - make this note difficult for the average investor to analyze, she said.

"You have a great deal of complexity because of the superposition of different barriers. First, the trigger event can happen any day. Then you have the call trigger above the initial price, which is observed quarterly. Lastly, there is the final barrier ... which will determine if you get all or part of your principal back," she said.

Correlation risk

"In addition to that, the notes introduce another layer of complexity with the two underlying components, an index and a fund. It's a worst-of product with only the worst of the two determining what you get paid at maturity," she said.

"Regardless of how sophisticated the investor may be, it's hard to grasp the different pieces of this. You have a lot of different moving parts and a lot of uncertainty."

One of the specific risks associated with a worst-of product is correlation risk, she said.

"If the index and the fund were highly correlated, you wouldn't have to worry about it. They would both move up or down in synch. It would be close to having one underlying asset," she said.

"It's when the correlation is low that it becomes more risky. The two underlyings move in different directions, which increases the chances of breaching the barrier. That's why the lower the correlation, the greater the risk and the more coupon you should get to be effectively compensated for taking that risk."

The JPMorgan note fits into one of Future Value Consultants' categories of structures called income-paying callable products.

Income without stocks

Investors in reverse convertibles tend to get higher coupon, but the underlying is most of the time a single stock, said Hampson.

"Given the low interest rates environment, in order to price a one-year income-paying product tied to something other than a stock and still get a decent enough coupon, the issuer had to be innovative," she said.

"A single stock has some volatility, which gives you a good premium. If they try to give people the types of coupons they're used to seeing with reverse convertibles but with a less volatile type of underlying, it's going to involve some risk.

"Either they have to use two underlyings or throw in a call feature. That's a little bit of what they've done here."

And yet, the product did not come up as excessively risky, she said, pointing to riskmap, Future Value Consultants' rating for risk on a scale of zero to 10.

Risk versus reward

The notes scored 3.51, compared with an average riskmap of 4.18 for all recently rated notes.

"These notes are a bit less risky than the average," she said.

"Despite the fact that it's a worst-of, we do have an index and a fund, which are less volatile than a single stock. We do have this deep barrier of 60%, which is much better compared to the 70% or 80% barriers you see on reverse convertibles. The worst-of adds an element of risk, but these two features end up making the product less risky than the average of what we've recently rated, which is largely dominated by reverse convertibles," she said.

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

"These notes are a short volatility play, just as reverse convertibles," she said.

"An investor would be quite happy if the underlying went nowhere and the barrier was never breached at [the] end of the year. You get your coupon and you get your money back. What you want is volatility to be contained."

This makes the low-volatility assumption the best scenario for this type of product.

Under a neutral scenario, the chances of losing more than 15% of principal would be 15%. When switching to a low-volatility scenario, this probability is reduced to 10.4%.

"The probability of losing that amount of capital is reasonable even under the neutral assumption because there is such a low barrier. However, if you hit that barrier, the chances of recovery are pretty slim and you are likely to incur heavy losses," she said.

On the upside, investors have a 31.4% chance of generating a gain comprised between 5% and 10% at maturity in the neutral scenario. This probability rises to 35.6% in a low-volatility market.

Price, overall

Future Value Consultants measures the market value of the underlying components of the product with its price score on a scale of zero to 10. Calculated as a percentage of the initial investment, the score gives an estimate of the fees taken per annum. The higher the score, the lower the fees and the greater value offered to the investor.

The notes' price score was only 5.90 against an average of 6.98 for all products.

"One reason could be that the options you're going to use in this worst-of are going to be less liquid, less transparent and more expensive than what you would find in a more standard S&P 500 product," she said.

"It could also be that this is a very specific product. It's for an investor who wants those two underlying [components], who needs income with the autocallable feature. You don't have that many products like this one and therefore not that much competition to keep the price under check."

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.

With an overall score of 5.97, the notes show a lower rating than the average of all products, which is 6.75.

"The price score is quite lower and the return score slightly less, so overall the product is not on the top of our ratings," she said.

"But for an investor looking for an income product that is not tied to a stock, someone who would prefer an index or a fund, there aren't that many options. As a result, notes like these ones may have their place."

The notes are expected to price July 20 and settle July 25.

J.P. Morgan Securities LLC is the agent.

The Cusip number is 48125VR77.

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