JPMorgan's reverse convertibles linked to Hess stock offer less risk than peers, analyst says

By Emma Trincal

New York, Sept. 14 - JPMorgan Chase & Co.'s 8.25% to 11.25% reverse convertible notes due March 22, 2013 linked to Hess Corp. shares are a more conservative product than most other reverse convertibles, said Gurdeep Ubhi, structured products analyst at Future Value Consultants.

The payout at maturity will be par in cash unless Hess shares fall below 65% 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 Hess shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

"The combination of a low put strike at 65% of the initial level and the relatively moderate implied volatility of 31% contributes to reduce the risk profile of the product," Ubhi said.

The coupon remains unknown given the three-point range between 8.25% and 11.25%. But according to Future Value Consultants' methodology, which assumes a value at 75% within the range, the hypothetical coupon used for the report is 10.5%.

Ubhi said that the product came out with very good ratings.

Deep barrier

"The average coupon for the reverse convertibles we have rated last month was 11.93%. This one is slightly below average but not amazingly lower. It's in the ballpark," he said.

"The interesting aspect of this deal is the 65% barrier, a much lower barrier than the average."

Recently rated reverse convertibles have an average barrier of 75%, he said.

"You have 65% versus 75%: that's a deep protection level for a reverse convertible," he said.

Of course with reverse convertibles, the protection is relative and depends on the implied volatility of the underlying stock, he said.

Typically, conservative barriers can be found with the most volatile stocks. They act as a way to balance the terms of a product, reducing some of the added risk, he said.

But it is not the case with these notes, he added.

"Right there, you see a lower barrier than average, a lower volatility than average and an annualized coupon that is around average even if it's slightly less. All this indicates good value before we even look at the score. A quick glance at the terms and the vol tells you right there that you are looking at a good deal," he said.

Investors in this product are not trying to maximize the upside by taking more risk, he said.

"There's no way you can say that people buying those notes would be risk averse. Obviously, all reverse convertibles are risky products," he said.

Conservative profile

"But this one is for someone who is not necessarily chasing after a high coupon. Rather, this is for someone who wants a fixed return with less chances of losing money," he said.

"I would say it's a little bit more conservative than the traditional reverse convertible.

"Typically a reverse convertible investor will expect volatility to decline so that the barrier hopefully won't be breached. Since there is risk, they also get that way a higher coupon.

"That's not what we have here. The deep barrier indicates at the contrary that the investor expects volatility to rise. This is why they want the extra protection. They want to minimize the chances of losing capital.

"The combination of a low barrier and a relatively low volatility makes this product quite appealing, especially because the coupon is still around average and has not been pushed down excessively."

Riskmap

The structure of the notes is built around a low level of risk compared to other reverse convertibles as measured by the riskmap.

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

The 2.08 riskmap of the notes is "well below" the average of similar products, he said, adding that it is mostly due to a reduced market risk.

"The low volatility and deep barrier together give you this low market risk," he said.

"It makes a big difference with other reverse convertibles whose average barrier is 75% with typically more volatility in the underlying stock."

Similar reverse convertibles have an average riskmap of 4.27.

The market riskmap of 1.69 for the JPMorgan notes is much lower than the average market riskmap of 3.68 for reverse convertibles.

The difference in terms of credit riskmap between these notes (0.40) and similar products (0.59) is less significant.

"The credit riskmap is not really a talking point here. Most reverse convertibles are short term, and the credit risk has less of an impact anyway," he said.

Risk versus return

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.

The notes received a 6.97 return score, compared with an average 6.13 return score for similar products.

"The return score is slightly higher than the average reverse convertible, and you may have expected more with such a deep barrier," he said.

"The difference has to do with a coupon that is slightly less than average, although we don't know for sure as it hasn't yet priced. A higher coupon would have pushed up the return score much more. But the difference between the two scores isn't that huge," he said.

The probability table associated with this product indicates a high probability of generating a profit.

When using the neutral assumption, which is a risk-free growth scenario, the notes show a 90.4% probability of getting a 5% to 10% annualized return. That probability rises to 92.2% when using the best among the five return scenarios, which for this product would be the low-volatility assumption.

On the downside, investors have 9.6% chance of losing more than 15% per annum, which is reduced to a 7.8% probability in the best-case scenario of a low-volatility environment.

"You have nothing in between those two buckets of losses and gains because the barrier is so low there is not much chance of recovery once you go down that far," he said.

Price, overall

The price score is Future Value Consultants' estimate on a scale of zero to 10 of the market value of the underlying components of the product. Calculated as a percentage of the initial investment, the score gives an estimate of value offered to the investor.

These notes have a price score of 8.46, compared with an average 6.71 price score for similar products.

"The product is competitively priced. It offers decent terms with the low barrier and the low volatility. You get some good protection for a low volatile stock, and they have not decreased the coupon by a whole lot. That's where the value comes from," he 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 overall score for this product is 7.72 versus 6.42 for the average reverse convertible.

"It has a good overall [score]. It offers good return and value to the investors in comparison to other products of the same type, which may have [a] similar coupon but a much less generous protection," he said.

The notes are expected to price Wednesday and settle Sept. 24.

J.P. Morgan Securities LLC is the agent.

The Cusip number is 48125V5U0.

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