JPMorgan's worst-of notes tied to Euro Stoxx, iShares MSCI EAFE offer high correlation, no cap

By Emma Trincal

New York, May 8 - JPMorgan Chase & Co. plans a worst-of structure designed for capital appreciation with leverage, uncapped upside and limited downside protection. Sources said they were surprised to see the relatively attractive terms built around two highly correlated underliers as low correlations usually allow for better terms.

JPMorgan plans to price 0% knock-out buffered return enhanced notes due Nov. 21, 2016 linked to the lesser performing of the Euro Stoxx 50 index and the iShares MSCI EAFE exchange-traded fund, according to an FWP filing with the Securities and Exchange Commission.

If each underlying component finishes at or above its initial level, the payout at maturity will be par plus 1.93 times to 2.01 times the return of the lesser performing component.

If either component declines but both finish at or above the 75% knock-out level, the payout will be par.

Otherwise, investors will be fully exposed to the decline of the lesser performing component.

High correlation

One characteristic of the structure is that it offers unlimited upside along with a satisfying level of downside protection, said Steve Doucette, financial adviser at Proctor Financial. The majority of worst-of deals cap the upside with a coupon, which most of the time is a contingent coupon, while leaving investors exposed to unlimited downside.

"I'm surprised they were able to give you such good terms considering how highly correlated those two indexes are," Doucette said.

The correlation coefficient between the Euro Stoxx 50 and the iShares MSCI EAFE is 0.95. One is the measure of perfect correlation.

Not typical

He explained that worst-of deals are structured to raise the coupon or call premium, which can be done more easily when the two or three underlying assets show little correlation with one another. That's because non-correlated assets increase the odds that one of the underliers will have a negative return even if the others don't. Options require a higher premium for that risk.

"Usually you get a coupon for those notes and not necessarily a fixed rate. The key is to find uncorrelated assets to get you a higher yield. I wonder how they were able to price this deal, which is no cap and some fair amount of downside protection with two underlying that behave almost like one," he said.

Doucette said that he has used worst-of deals before but for fixed-income purposes, in search of a higher yield, not for growth as this product is designed for.

The typical income-oriented worst-of deal would be an autocallable with a longer maturity and two non-correlated asset classes, such as the Russell 2000 index and the Euro Stoxx 50 index for instance, which would be U.S. small cap versus European large cap. Typically when both indexes close above a barrier level on an observation date (often quarterly), investors receive a coupon. When both close above their respective initial prices, the notes are called and the final coupon is paid. At maturity, if there has not been any call, the breach of the barrier by just one of the indexes would trigger a full downside exposure to the worst performing underlier.

Asset allocation

"We've used those worst-of with a coupon before. We like them. They protect you against interest rate risk, and we think rates are going to rise. They pay a higher yield than the normal autocall. But they're for income. I use them in my fixed income bucket," he said.

"Obviously with this one - double leverage, no cap and a 25% barrier - you're talking equity allocation.

"This is definitely part of an equity replacement. The risk-reward profile is different. You have unlimited downside, but you also have unlimited upside and it gives you some level of protection."

Income-oriented worst-of deals may offer higher levels of protection, in some cases 40% to 50%, than the protection associated with this product, he noted.

"But as we enter a new market cycle, you have to ask yourself, can you really afford to take that kind of equity risk for a fixed-income replacement?" he said.

Barrier

The JPMorgan deal offers equity risk as well but with unlimited upside, which gives the product a special appeal, he added.

"Any time for an equity replacement you get double leverage, protection and no cap, you have something quite interesting. On top of that, you have two highly correlated indexes. How much different are they going to be? Worst-case scenario, you're long one of them and in this case, you're long the market," he said.

On the downside, Doucette said the barrier significantly reduces the odds of losing principal.

"That's the perfect storm if you hit the maturity with a 25% decline in the index," he said.

"Otherwise, you get two times the worst of the two or your return of principal.

"I like the 25% contingent protection. To breach that kind of barrier you would have to have an above-average bear market decline."

Matt Medeiros, president and chief executive of the Institute for Wealth Management, also found the notes attractive, especially the correlation factor.

The Euro Stoxx 50 index is an equity benchmark for the euro zone. The iShares MSCI EAFE fund tracks developed countries excluding the United States and Canada. About half of its components belong to euro zone countries, according to BlackRock's iShares website.

Return enhancement

"I like the high correlation between those two asset classes," he said.

"First of all, it's easier to track and to understand.

"But more to the point, I like the idea that if the worst of the two is positive, I get the two times leverage with unlimited upside. That's attractive because I expect these two underliers to have decent returns, not stellar, but I'm optimistic enough to see growth for both of us. And the leverage would enhance the performance.

"I'm also optimistic enough to think it's unlikely that either one of those two indexes would drop by more than 25% two and a half years from now. I don't anticipate that kind of market movement with any of those two underliers in that timeframe."

For mildly bullish investors, the leverage embedded in the structure could be helpful.

"I like Europe, but I'm not extremely bullish. These countries are improving. I see the potential for market expansion. But I don't see potential returns like the S&P has had last year," he said.

Fewer triggers

"This is a deal you would get into for capital appreciation," he said.

"It's very different than your typical autocallable worst of.

"One of the differences is simplicity. You don't have a series of triggers, one for the call, one for the coupon, another for your repayment at maturity.

"I like the fact that you don't have to manage all sorts of triggers.

"Basically, I like a lot of things in this deal, such as the high correlation, the fact that it's relatively short term as well as the upside kicker."

J.P. Morgan Securities LLC is the agent.

The notes will price May 16 and settle May 21.

The Cusip number is 48127DHK7.

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