JPMorgan's four $50 million deals linked to junk reference assets suggest institutional bids

By Emma Trincal

New York, May 20 - JPMorgan Chase & Co. issued four $50 million offerings of tracker-like notes linked to credit underliers, intriguing sources for the use of a less common underlying asset class and the size of each offering.

They speculated that the buyers must have been institutions, pointing to the appeal of the fixed-income underlying asset class, the size of the issues as well as the 5% annualized fixed rate offered in each product and payable monthly. But they remained unclear about the reasons behind the heavy bid given the fees, which they said were high in proportion to the short duration of the products, especially when cheaper ETF alternatives are available.

One assumption was that institutions may have bought those products due to credit restrictions in their mandates, seeking indirect access via a note to sub-investment-grade assets, one source said.

"The structures are pretty simple. It's the underlying that's more interesting," a market participant said.

"It's about time that people start looking at these underlying assets. Credit is a very interesting asset class right now."

Four $50 million deals

The first series of two quasi-identical offerings was based on a high-yield bond benchmark designed to reflect the performance of the U.S. dollar high-yield corporate bond market.

JPMorgan priced $50 million of 5% annualized return notes due Sept. 25, 2013 linked to the iBoxx $ Liquid High Yield index, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be $980.30 plus the index return, with exposure to any losses.

The Cusip number was 48126DV55.

There was no fee, but for each $1,000 principal amount of notes, investors receive at maturity only $980.30 plus the index return. The difference, called in the prospectus the "downward adjustment," represents a 1.97% cost to the investor over the term of the notes.

The same day, JPMorgan sold another $50 million of similar notes (Cusip: 48126DV63). The only difference was the downward factor as investors will get $980.70 for each $1,000 principal amount, the equivalent of a 1.93% fee.

The third and fourth offerings were both based on the PowerShares Senior Loan Portfolio ETF. The fund, listed on the NYSE Arca under the symbol "BKLN," invests in loans that are expected to be below investment-grade quality and to bear interest at a floating rate that periodically resets. It seeks to replicates the S&P/LSTA U.S. Leveraged Loan 100 index, which tracks the market-weighted performance of the largest institutional leveraged loans based on market weightings, spreads and interest payments.

JPMorgan priced $50 million of 5% annualized return notes due July 22, 2013 linked to the PowerShares Senior Loan Portfolio, according to a 424B2 filing with the SEC.

Investors receive at maturity $998.10 for each $1,000 principal amount plus the fund performance. The cost to the investor was 19 basis points on a two-month duration.

The Cusip number was 48126DV30.

An almost identical note offering (Cusip: 48126DV48) was sold on the same day for the same $50 million amount. The only difference was the downward factor as investors receive $993.80 out of par, the equivalent of a 62 bps fee.

Bonds versus loans

"The size of these offerings is significant," the market participant said.

"Perhaps it reflects a new trend. There's an opportunity now to structure notes around high-yield credit instruments, whether bonds or loans. That's because people are more and more comfortable taking on credit risk.

"It's just a matter of time before people go to structured products tied to those reference assets as a way to express their views. It shows that the market is comfortable with credit risk. I can see more of similar offerings coming up."

A financial adviser noted that the coupon may have driven the size of the offerings.

"I guess they sold a lot of it because of the fixed income rate," said Carl Kunhardt, wealth adviser at Quest Capital Management, referring to the 5% annualized interest rate paid on each of the four deals.

Yet, he said that he was skeptical about the value of the notes for an individual investor.

"The bottom line is those notes don't really attract me. You're getting a coupon, but the issuer is taking in fairly high fees - I mean for the bond deal - given that this is a bond index underlying and that it's very short term. That's smoke and mirror to me," he said.

Kunhardt compared the fee structures of the notes with ETFs.

An equivalent ETF for the bond index would be the iShares iBoxx $ High Yield Corp Bond ETF, listed on the NYSE Arca under the symbol "HYG" with a 50 bps expense ratio. It compares advantageously to the fees on the two iBoxx $ Liquid High Yield index notes, which were 1.93% and 1.97%, he said.

"The bond one doesn't strike me as something I'd be paying attention to. They're taking in the most fees," Kunhardt said.

"You have this HYG ETF with a 50 basis points fee as a pretty solid alternative. Why wouldn't you do this ETF, which is much cheaper than the notes? I don't see a compelling reason.

"The idea of high-yield investing is not a bad one. There is a lot of concern about the high-yield market. But it's not really an issue for a bullish investor as there is a strong correlation between high-yield and equity. Therefore, if equity continues to do well, high yield should continue to generate good returns as well.

"I'm more uncomfortable about the cost of those super short notes."

Kunhardt said that he may be more "intrigued" by the other two offerings referencing the senior loan fund.

"I'm not saying I would buy it. But I could consider it. The case for this one is easier to make. First of all, it's cheaper than the other, or at least, there's not such a huge gap with the ETF," he said.

The PowerShares Senior Loan Portfolio ETF listed on the NYSE Arca under the symbol "BKLN" has a 66 bps expense ratio versus 19 bps and 62 basis points for the two PowerShares Senior Loan ETF-based notes, he said.

Kunhardt said that he liked the senior loan asset class better than the iBoxx Liquid High Yield index.

"Those senior loans, issued by banks, represent very short-term financing with floating rates. So investing in this asset class gives you floating rates. It's a good asset class to hold in an inflationary period. Such short-term paper is reset very quickly and your interest rates rise with inflation," he said.

"I imagine that the senior loans notes were sold to institutions. It was probably designed as a hedge for an institutional portfolio. The fact that it's very short term suggests that those products are likely to keep rolling once they mature. If you're using floating rates as an inflation hedge, that wouldn't be a bad thing.

"The lower fee is what makes it attractive compared to the other one. It's an inexpensive way of doing that strategy."

The leveraged loans as an asset class offered other advantages over high-yield bonds, he said.

"Those senior loans are probably the highest junk issues that you're going to find, and senior floating-rate paper will be higher in the capital structure. While a pure high-yield bond may give you back 30 cents on the dollar after default, you may get 70 cents on a senior loan," he said.

Kunhardt concluded that the buyers of the deals must have been one or several institutional investors.

"I don't think it was done for retail investors. Retail investors would just go with the mutual funds," he said.

"There are four $50 million offerings out there. That's pretty impressive.

"Obviously somebody found it attractive.

"But I'm not that excited about it. If you're going to track, why go through the trouble of a structured note, especially on a short period of time?"

Access to junk

The market participant noted that both pairs of deals were pretty similar.

"You just buy a note linked to these things, but there is no derivative, such as a knock-out or a buffer. They're both simple trackers with no principal protection obviously, although one can argue there is some aspect of principal protection because these underlyings are supposed to be pretty stable except for the credit risk.

"The main question would be why using these notes versus an ETF?" he said.

At first, the market participant assumed that the fixed interest rate must have been the hook for investors looking for defined, predictable cash flow.

"But when you look at the maturities of those products - two months and four months - the appeal of the coupon is not a theory that makes a lot of sense. It's with a longer trade that you would want to secure a fixed coupon. But for four months, why bother doing a note? It makes even less sense when you look at the fee. Paying 1.93% for four months, that's not cheap. I have to say, I can't really tell why people bought it and why it sold so well," he said.

"I can only see one explanation, and it's pure speculation on my part. These products would have been purchased by institutional investors who are prohibited from buying junk, whereas if you buy a note issued by a single-A issuer like JPMorgan, you can go around a problematic mandate.

"That type of rationale would make sense.

"Maybe it was just a way to buy some investment-grade paper with some junk underlying.

"It's sort of silly because even if your issuer is investment grade, the reference is still high yield.

"But the mandate restrictions may explain the big size deals, which would suggest that the investors were probably institutions driven by yield."

J.P. Morgan Securities LLC was the agent for all products.

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