JPMorgan’s dual directional notes on two indexes to offer potential alpha, no cap

By Emma Trincal

New York, Sept. 7 – JPMorgan Chase Financial Co. LLC’s 0% dual directional contingent buffered return enhanced notes due Sept. 30, 2021 tied to the Russell 2000 index and the S&P 500 index give investors an absolute return on the downside and unlimited upside exposure in exchange for a significantly small amount of leverage over a four-year term.

Advisers agreed that the terms made the product compelling but the upside leverage solicited more of a mixed review, which were generic in essence.

If each index finishes above its initial level, the payout at maturity will be par plus at least 1.1 times the gain of the worse performing index, according to a 424B2 filing with the Securities and Exchange Commission.

If either index falls by up to 30%, the payout will be par plus the absolute value of the return of the worse performing index.

Otherwise, investors will lose 1% for each 1% decline of the worse performing index.

Four-year term

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said that the structure for the most part was attractive on both the upside and the downside.

“It seems to be pretty straightforward,” he said.

The defensive aspect was to be found in the longer tenor not just in the size of the contingent protection.

“While the two indices are relatively correlated, having a barrier generally makes me nervous. But with a four-year note, I am more comfortable with the barrier.”

He based his opinion on back tested performances, which he regularly reviews for his market analysis.

Those show lower probabilities of loss as time expands.

“You’re less likely to breach this 70% barrier on a longer-dated note than on a short-term product,” he said.

“I still prefer a buffer. But the fact that the barrier is observed point to point over a four-year timeframe somewhat takes care of some of the downside risk. So I can live with that.”

The barrier also enables investors to strongly outperform the worst-performing index on the downside.

“The absolute return characteristic is the significant benefit of this product,” he said.

Leverage, not a factor

However, the leverage was not even a factor in his decision process.

“Whether 1.1 times is a little bit of leverage or not, I’m not a big fan of leverage on high-standard-deviation products,” he said.

“In this case, the leverage is nice but would not be part of my consideration.

“The fact that it has no cap and that you can outperform the market on the downside are much more appealing features to me.

“The leverage from my own standpoint is inconsequential.”

Holding hands

For others however the leverage has some impact, at least in terms of clients’ concerns about what they read on paper and the necessity to alleviate their fear.

“It’s one of these things...When you’re levered up you’re levered down,” said Steve Doucette, financial adviser at Proctor Financial.

He did not suggest the downside was leveraged. He meant that during the life of the notes, the value of the investment will be affected by leverage whether the price goes up or down when the move takes place above the initial level.

Such moves, especially a rise in the price followed by a pullback, may have no immediate consequence if the notes are held until maturity but may cause concerns when clients review their statements.

“The option is not fully valued until maturity. You can’t get full price for the notes you’re holding because you can’t fully value the optionality. It can go either way,” he said.

As an example he imagined a four-year note with two-times leverage on the upside.

“We’re two years into a four-year. The market is up 10%. You’re not getting 200% in value because you’re half way through the notes. Chances are it will be priced 115, so you’re not capturing 200%. You’re capturing 50%.”

“It’s not a gain or a loss until it’s sold. But I like less leverage from an optical perspective because the leverage works both ways. It can lever down the value of the notes,” he said.

The worst situation, he explained, is when a price appreciation is followed by a decline. In such case, investors will look at their last statement and “feel” the drop because all price moves are leveraged above the starting point.

For instance if a 10% price decline in the index drives back the value of the notes formerly at the hypothetical 115 level in his example to 100, a lot of explaining will have to be done with clients. This is one of the reasons Doucette does not hesitate to put back a note to the issuer when it makes sense.

“If I’m up 15, I may want to take it off the table before it goes back down to 100,” he said.

More is still better

As the 1.1 leverage factor of the notes is relatively modest compared to a factor of two or three, the “optics” of the notes may be better, he said.

In this case, the small leverage will help address clients’ questions on valuation during the life of the product.

It also provides better terms.

“That tiny leverage of 1.1 is what gives you the no cap. You would be capped if they gave you more leverage. And they may not have been able to put the absolute return in there,” he said.

But since nothing is in black or white, Doucette added that given the choice, he would still prefer more leverage than what the deal offers.

“Less leverage is maybe less likely to raise eyebrows if the market goes up and then down.”

“But we like a little more leverage.”

Bear lurking

Finally, Doucette was not convinced that the barrier size was sufficient.

“The absolute return gain could be huge. The market could be down and recover,” he said.

“Unfortunately we don’t know the timing of the next bear market.”

But statistics are available on the intensity of losses, he added.

The last 10 bear cycles since the Crash of 1929 reveal an average loss of 45%. The average length of those bear cycles has been 24 months, according to data from JPMorgan Asset Management from July 31, which he quoted.

“Your 30% barrier doesn’t cover your average.

“You can only hope that within four years you’ll have enough time for the market to drop and come back up.”

Despite those objections the terms of the product were compelling, he said.

“I do kind of like it.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price on Sept. 26.

The Cusip number is 46647MZ71.

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