JPMorgan notes tied to iShares MSCI Brazil offer defensive range-bound trade, sources say

By Emma Trincal

New York, Feb. 9 - JPMorgan Chase & Co.'s sale of knock-out notes tied to the iShares MSCI Brazil index fund may appeal to investors who believe Brazilian stocks will trade within a range but who need downside protection, sources said.

JPMorgan priced $3.93 million of 0% knock-out notes due Aug. 11, 2011 linked to the exchange-traded fund, according to a 424B2 filing with the Securities and Exchange Commission.

If the ETF's share price is less than 70% of the initial share price during the life of the notes, the payout at maturity will be par plus the fund return. Otherwise, the payout will be par plus the greater of the fund return and the contingent minimum return of 21%. The return is capped at 40% in either case.

J.P. Morgan Securities Inc. is the agent.

Appealingly priced

"It's a very appealingly priced security," said a market participant. "There are lots of ways of making money. The returns are kind of interesting."

The notes offer some additional protection when compared to a direct investment in the ETF, this source said.

"If the fund stays in the 30% [decline] to 40% [cap] range, you can make 21% on the upside, even if the fund is down as long as you don't break the 30% barrier. And you can make dollar-for-dollar up to 40%. It is still very appealing even when compared to a direct investment into the fund. You can buy the ETF outright and still lose money wherein here, you're protected up to a 30% decline."

Knock-out risk

This market participant said that on the downside, one of the "possible issues" is that it "is easy to hit the barrier" and therefore, one can easily lose the benefit of the 21% contingent minimum coupon, because "all it takes is one time" during the term for the ETF to break the barrier.

"And I think there is a risk because even if the U.S. market is flat, emerging markets can without difficulty hit that 30% decline during the next 18 months," she said.

Range-bound trade

"It's a range-bound trade," said Lane Jones, chief investment officer at Evensky & Katz Wealth Management in Coral Gables, Fla. "If you're someone who believes that Brazil will trade between 30% on the downside and 40% on the upside, then you're going to like that trade because it's got some downside protection and it can give you the returns you anticipate on the upside."

The iShares MSCI Brazil index fund posted a 65% gain over the past 12 months.

Jones said that during the term of the notes, an investor could either lose more than 30% or make between 21% and 40%. As a result, paying attention to the standard deviation of the underlying is important for investors.

The iShares MSCI Brazil index fund, a single-country ETF with a concentrated portfolio of stocks, carries a five-year standard deviation of 37.47%. "In any one-year period, you would expect a deviation of less than 37.47%," said Jones. "The cap seems pretty reasonable on the upside," said Jones, comparing the standard deviation to the 40% maximum return.

"If you thought the underlying would go straight up, then you would invest directly in the ETF. And if you thought there was a risk of losing more than 30%, you wouldn't consider it because the buffer wouldn't be hard enough for you," added Jones.

"It may sound strange to use the term 'range-bound' when you talk about emerging markets, but that's what you have here. If you get a client who wants to invest in Brazil with the understanding that this ETF does not give him exposure to the entire Brazilian exchange and if this client wants some amount of downside protection, then it's not a bad range-bound trade," Jones said.

Hedging the range

From the issuer's standpoint, hedging the risk is important, the market participant said. The bank, she said, is better off in two cases. First, on the downside when the barrier is breached because after a decline of more than 30%, the issuer's obligation to pay the minimum coupon disappears. Second, on the upsize when the fund gains more than 40% since the payout is capped at that level, saving the bank the excess return.

"The bank has to hedge itself because they're paying out when the fund stays in the 30% [loss] to 40% [cap] range," this market participant said. "So they have to hedge the positions within the range. Outside the range, they're making money."

Same deal, same distribution

As Brazil was one of the top emerging markets last year, the use of the iShares MSCI Brazil ETF has grown in popularity and more issuers are structuring notes around this ETF, whose shares doubled in price in 2009.

For instance, HSBC USA Inc. on Thursday priced $8.1 million of 0% knock-out buffer notes due Aug. 4, 2011 linked to the iShares MSCI Brazil index fund.

The structure was the same except for a higher contingent minimum return of 23.4%.

JPMorgan was involved in the HSBC deal as well: J.P. Morgan Securities was the agent.

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