JPMorgan's capped leveraged notes linked to MSCI EAFE seen as risky, rewarding bull play

By Emma Trincal

New York, Feb. 27 - JPMorgan Chase & Co.'s 0% capped enhanced participation equity notes due Sept. 1, 2015 linked to the MSCI EAFE index are an attractive option for investors bullish on developed countries, but not everyone is willing to take that bet without downside protection, sources said.

The index is focused on developed markets in Europe, Australasia and the Far East.

The appeal for bulls is the upside, according to sources.

The payout at maturity will be par plus 1.75 times any gain in the index, up to a 28% to 33.25% cap that will be set at pricing. Investors will share in any losses, according to a 424B2 filing with the Securities and Exchange Commission.

"If you look at the EAFE index and its components, they all have underperformed the S&P," said Steve Doucette, financial adviser at Proctor Financial.

The top countries in the MSCI EAFE index are the United Kingdom with a 21% weighting, Japan (20%) and Switzerland (9.70%). Two large euro zone countries come next, France (9.60%) and Germany (9.35%). Australia is No. 6 with a 7.5% weighting.

"Japan recently started to surge a bit, but in the past two or three years, it has underperformed the U.S. market," Doucette said.

Over the past three years, the S&P 500 has gained 40.5% versus 1% for the MSCI Japan index. Over the past 12 months, the Japanese index has gone up 14% versus 22.35% for the S&P 500.

Reversion to the mean

"If you're bullish on the world economy, it's a great way to capture the upside with the leverage component," Doucette noted.

"The cap is pretty good too. Who is going to complain about a 30% return over 18 months?

"If it's your view that the index will continue to go up, then it's a good way to express it and bet that the EAFE will go where you want it to go.

"Even if you're slightly bearish, you know that you are not going to outperform on the downside, but if you have a long-term view, it might be all right."

While the term of the notes is relatively short, Doucette said that a lot could happen in the 18-month timeframe.

"I would tend to be bullish from a reversion to the mean perspective," he said.

Leveraging up

Over the past 12 months, the S&P 500 has gained 22% while the MSCI EAFE index has risen 15%.

The S&P 500 has outperformed the MSCI EAFE index by nearly 60% over the past five years.

"The EAFE index has underperformed the S&P for a while, and at some point you'll see a reverse of the trend. We could have a correction of course, but for the 18-month period, hopefully we would have passed it.

"If you believe that non-U.S. developed countries are due for a rebound, if you think they are about to outperform the U.S. market, if that's your view, you might as well have it leveraged up.

"If you're willing to take the risk on the downside, you still benefit from a one-to-one downside exposure while you're getting 1.75 times on the upside.

"These are very enticing terms for a bullish investor."

The missing term

Matt Medeiros, president and chief executive at the Institute for Wealth Management, said he is bullish on the asset class but not necessarily interested in expressing his market view through this type of structured note.

"It's a pretty straightforward structure. I like the asset class. I believe there are good opportunities for growth in the non-U.S. developed countries," Medeiros said.

"EAFE stocks continue to show promise in appreciation. The GDP expectations for those countries are improving. Some of the currency issues tend to be behind us. Many of the countries have shown positive growth, a real progress from a recent past."

But the absence of any downside protection is a "concern," he said.

"I understand that the structure provides leverage on the upside to enhance the underlier's return, but with that, I would prefer to see some downside protection," he said.

"I'm aware that the upside is leveraged while the downside is not and that you have 1.75 times on the upside and one-to-one on the downside, which looks good for the investor. Still, it's not enough to make me feel comfortable."

Leverage is not enough

Medeiros said that his reluctance to consider a note with no downside protection is not necessarily limited to this particular product.

"My concern is based on the standard deviation of this particular asset class. But it's also due to the nature of the investment that I'm buying if I decide to buy a note instead of buying the equity," he said.

"If I was to take an additional risk with credit risk and to surrender a bit of liquidity, I would need to get more than just leverage on the upside. I would want to be able to mitigate the extra risk. That's pretty much what I tend to think about most leveraged notes."

The notes (Cusip: 48126N4Y0) were expected to price Thursday and will settle Wednesday.

J.P. Morgan Securities LLC is the underwriter.

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