JPMorgan's $24.22 million 15.2% notes on International Paper well bid due to coupon, technicals

By Emma Trincal

New York, Aug. 19 - JPMorgan Chase & Co.'s $24.22 million of 15.2% annualized yield optimization notes with contingent protection due Feb. 23, 2011 linked to the common stock of International Paper Co. were well received given their high coupon and the stock's low price, sources said.

"I think it's a pretty decent deal," an option trader said about the notes. "Yes, your upside is limited to 7.6% for a six-month note. But that's more than what you earn from a bank or Treasuries. I don't know where you can get that type of coupon for six months."

Each note has a face value of $21.59, which is equal to the closing price of International Paper stock on the pricing date, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable monthly.

The payout at maturity will be par unless the final price of International Paper stock is less than 75% of the initial share price, in which case the payout will be one share of International Paper stock per note.

Buy-write like

The trader said that the notes were the equivalent of a buy-write, an option position created by simultaneously buying the stock and selling a call option on it.

On the upside, the coupon is the equivalent of a premium paid to the investor for selling a call, he explained.

"You sell a call at a strike of 7.6%. Like a buy-write, there's no upside above 7.6%," he said.

But he described the downside as slightly different.

The coupon is designed to compensate investors for the risk of losing some or all of their principal, according to the prospectus.

"It's not a perfect buy-write because your loss is the price of the stock minus the premium," the options trader said. "Even if the stock goes to zero, you get to keep the premium. And it's a pretty high premium," he said.

Risk/return parameters

Investors buy the notes for the high coupon paid over a short period of time on the view that the stock is likely to "trend sideways," according to the prospectus.

Yet the bet requires a "moderate to high" risk tolerance, the prospectus also stated.

For some investors, it's not so much the risk that poses the problem but rather the asymmetry between risk and reward.

"Your return is 7.6% at the max. And your potential risk is unlimited. I don't think these parameters make sense," said Steve Doucette, financial adviser at Proctor Financial.

Doucette said that in general, he invests in structured notes linked to an index or a diversified basket of securities.

"I would much rather see a deal like that on a basket of stocks, but of course they couldn't structure it with such a high coupon since the volatility would be much lower than the volatility of a single stock," he said.

Doucette said that the notes were designed for investors seeking income.

Yet, he would not consider this type of product, preferring alternative strategies for that investment objective.

"I think there are smarter ways to collect a coupon," he said.

Among those, he mentioned investing in "steepener" or "flattener" notes linked to yield curve spreads. "They also pay a high coupon, and at least it's a bet on the market," he said.

Other options may include a bank loans fund or even a diversified basket of stocks that pay high dividends, he added.

Contingent protection

The option trader said that investors in the reverse convertibles and investors buying the stock outright had similar risk profiles, despite the contingent protection offered by the structure.

"Your risk is that the stock can go down to zero and you get nothing back. But you do get a little bit of a premium," he said. "Your risk is the same as being in the stock."

This trader noted that the coupon was high because the underlying stock was volatile.

"The higher the downside risk, the more premium you get as a compensation for it," he said.

Assessing risk

The trader said that while both the barrier and the coupon were attractive, investors still needed to have a view on the underlying stock.

"Basically the question is whether you think the risk is a good risk," he said.

Simplifying the deal figures to make his point, he used a face value of $20.00 for the notes.

He calculated the "capital at risk" by subtracting the earned return - or 7.6% of the face value, which he said "is roughly $1.50" - from par, leading to a value of $18.50, which represents the amount of par that is at risk.

"Ask yourself if you want to risk $18.50 for $1.50. That's what you need to decide based on your view of the stock. But people risk a lot more than that," he said.

Near low

International Paper produces and distributes printing paper, packaging, forest products and chemical products.

The stock is highly volatile, said Ryan Detrick, senior equity analyst at Schaeffer's Investment Research. The shares are down 20.5% year to date, not far from their 52-week low, he noted.

"It's at the lowest end of its range. From a chart standpoint, it's reasonable to think that it will hold. The odds are slim that the stock would go through a 25% drop anytime soon," he said.

Buying signals

One concern was a high put volume around the stock. But Detrick said that the put activity was not necessary a bearish signal.

"A lot of puts have been coming in, but it's tough to say how long that's been there. Those puts could be bearish or neutral. Our guess is that a lot of hedge funds may be long the stock and are hedging their bets," he said.

Investors in the notes are in the money as long as the stock does not fall by more than approximately $5.00 six months from now.

Detrick said that such positive outcome was "reasonable to expect" and that it was "a good time to buy" based on the chart.

"It's at the lower range. As long as it holds, the trade makes sense," he said.

"Then again, like most big blue chips, the market will be the major deciding factor."

International Paper is in a sector seen to be resilient when the economy slows down, which may help in case of a market sell-off, he said.

"It's a consumer staples and a defensive stock. Therefore it's likely to be holding up a little bit better than Nasdaq stocks for instance," he said. "I think there are good reasons to think the stock has some support."

UBS Financial Services Inc. is the underwriter.

Fees are 1%.

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