JPMorgan’s leveraged notes linked to iShares EM offer conviction play with sizable buffer

By Emma Trincal

New York, Nov. 23 – JPMorgan Chase & Co.’s 0% capped buffered enhanced participation equity notes due Jan. 26, 2018 linked to the iShares MSCI Emerging Markets exchange-traded fund offer good terms, including protection for investors who “have the stomach” for the distressed asset class, said Clemens Kownatzki, independent currency and options trader.

If the fund return is positive, the payout at maturity will be par plus 160% of the fund return, subject to a maximum payout that is expected to fall between $1,280 and $1,328 per $1,000 principal amount of notes. Investors will receive par if the fund falls by up to 20% and will lose 1.25 times each 1% decline beyond the 20% buffer, according to a 424B2 filing with the Securities and Exchange Commission.

Contrarian bet

“I find it relatively attractive. I’m a bit of a contrarian. Emerging markets have been under a lot of pressure,” said Kownatzki.

He pointed to the 11.5% decline in the ETF this year, adding that falling commodity prices worldwide had a very negative impact on emerging market valuations.

“But prices don’t stay negative indefinitely. Eventually, a recovery could create high returns for investors making a bet on a reversal,” he said.

In the global environment, the relatively healthy U.S. economy could spread to other markets, he predicted.

“The U.S. economy continues to strengthen. U.S. disposable income as a result is rising. U.S. consumers are buying more goods from China, which is important considering that China’s growth is export-driven. This leads me to believe that China along with emerging markets are poised for a rebound,” he said.

Protection

The 20% buffer adds a lot of value to the investment, he said.

“Even with the gearing, you’re still much better off than if you owned the fund,” he added.

The severity of the current pullback in emerging markets is beginning to look like a bottom, he noted.

“Look at Brazil: down 50% in the last two years. ... These types of bear markets never last forever.

“If you have a contrarian mind, you can see a possible trend reversal.”

For investors who fear not having enough protection, options offer ways to reduce risk further.

“This ETF is very liquid. You can trade it like a stock. If you have concerns near maturity, you can always find a way to hedge that ETF.”

Underweight

Carl Kunhardt, wealth adviser at Quest Capital Management, was more critical. He liked some of the terms but said he would not buy the notes due to his view on the underlying asset class. In addition, geared buffers are not a popular feature among his investors.

“We’ve recently reduced our allocation to emerging market equity from 5% to 3%,” he said.

Moreover, the asset management firm only allocates 1% to non-U.S. emerging market bonds.

“We’ve cut the emerging market bond allocation due to the cost of hedging currency risk, and we’ve cut the equity allocation because the risk return just wasn’t there.”

Kunhardt said he is “underweighting” emerging market stocks because of an excess of volatility, the volatility itself being driven by a decline in commodity prices.

“Emerging market countries are the major commodity exporters. When commodity markets get hit, emerging market stocks underperform,” he said.

Because his 3% allocation to emerging market stocks is so small, Kunhardt said he has little use for a structured note.

“We mitigate risk by being small. We don’t really need a sophisticated product with leverage, cap and buffer. It’s not in our core portfolio. If we see more risk, we’ll just continue to cut our exposure,” he explained.

Kunhardt conceded that the terms of the product are not bad.

“It seems like a reasonable note. It has an interesting upside leverage and cap. Two years is good. You’re not rolling the dice for a long time,” he said.

“But it’s a satellite asset class. It’s not my core.

“My main objection is a factor of where the note is playing in.”

Too complex

Kunhardt also objected to the geared buffer, which he said adds another layer of complexity.

“Since I’m not particularly interested in emerging markets, why in this context would I be introducing to my clients a complicated instrument?” he said.

“If I have to spend more than five minutes with a client to explain the note, I don’t want it,” he noted.

For Kunhardt, the buffer rate of 1.25 applying to any fund decline beyond 20% is an example of complexity.

“Anytime you introduce leverage you complicate the issue, especially on the downside,” he said.

“Clients may understand it, but they understand it emotionally. They don’t like it.”

Geared buffer

He compared the deal’s geared buffer with a standard 20% buffer. With the JPMorgan note, a 35% decline at maturity would generate an 18.75% loss to the investor. The same loss applied to a traditional buffer would cause investors to lose 15%.

“I know that I’m only losing 3.75% more than what I would be losing with the traditional buffer,” he said.

“I know that by losing 18.75% instead of 35%, I outperform the benchmark.

“But I’m an adviser, not a client.

“Most industry professionals live in a relative world. They see that you lose much less with this note than with the ETF. You outperform the benchmark. So they like it.

“But a client doesn’t think in terms of benchmark. A client will look at this 20% buffer versus the 20% he’s used to and he will ask, how come I’m losing almost 19% and not just 15%?

“That’s how investors think.

“That’s the challenge of being an adviser.

“So I just want to keep it simple because I don’t want to have that kind of conversation.”

J.P. Morgan Securities LLC is the agent.

The notes (Cusip: 48128GDL1) will settle on Dec. 1.

© 2015 Prospect News.
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