JPMorgan reverse notes have hybrid structure; Lehman worst-performer risky; surge in Elements issuance

By Kenneth Lim

Boston, Feb. 22 - JPMorgan Chase & Co.'s 13.05% reverse exchangeable linked to the common stock of Citigroup Inc. has caught the attention of analyst Suzi Hampson because of an unusual barrier structure that falls between a typical barrier and a buffer.

"I haven't seen anything like this," Hampson, an analyst at Future Value Consultants, told Prospect News. "I don't know if there have been similar products, but I personally haven't seen a structure like this."

JPMorgan announced an issue of 13.05% reverse exchangeable notes due Feb. 26, 2009, linked to Citigroup's common stock. The notes will pay the principal plus interest at maturity as long as Citigroup's final share price is at least 65% of the initial share price. Otherwise the payout will be the number of shares equal to par divided by the final share price.

The point-to-point nature of the product differs from more typical reverse convertibles, which have barriers that are observed throughout the life of the notes, Hampson explained. For example, reverse convertibles will usually only protect the capital if the underlying price never falls below the barrier level during the life of the note and ends at or above the initial level. In this case, the only observation point is at the end of the note's life.

"Here the risk is only based on the final level of the stock," Hampson said.

Hampson said the structure was almost like the buffer level on acceleration notes. But in buffer structures, the erosion of the principal is only for however much the underlying finishes below the buffer level.

"I haven't actually priced it, but it would be interesting to compare it between something with a barrier and a buffer," Hampson said. "This way, it makes it more susceptible to change near the end of the product term than with a typical barrier."

Hampson said the structure was not necessarily more or less risky than a standard reverse convertible.

"I guess it would be up to the preference of the investor," she said. "Maybe if they thought that over the next six months the stock is likely to fall below that particular level but it might do even better later. I think the risk profile would be pretty similar [with a typical reverse convertible]. It would just depend at what point you measure it."

Lehman's least-performer risky

Lehman Brothers Holdings Inc.'s $2 million offering of semi-annual review notes with contingent protection due Feb. 24, 2010, linked to the worst-performing common stocks of Wachovia Corp. and JPMorgan Chase & Co. is riskier than most other recent products, Hampson said.

The notes are automatically called at increasing premiums if the closing price of each of the stocks is above its initial level on any of four semi-annual review dates. But the chance of a call occurring beyond the first or second opportunities is slim "since it is conditional on not having satisfied the earlier test," Future Value wrote in a report. "The underlying is likely to be significantly below the next target level and would require a large increase."

If the notes are not called early and either of the stocks falls below its trigger level - 60% of its initial level - during the life of the notes, the payout will be a number of the worse-performing shares equal to par divided by the initial price of that the stock.

"We see this structure quite regularly," Hampson said. "Usually it's two indices. Using two individual stocks, they have more volatility than indices, and that's what enables them to have higher returns, and it's quite high returns here. The fact that they're banks also suggests the volatility will probably be quite high, and we've seen quite a number of products linked to banks. The sector is pretty popular at the moment."

The product is riskier than most recent products - even those that offer similar overall value, Future Value noted, but it offers potentially early return.

"The potentially high returns are a result of the volatility of the underlying and the fact that you're linking your principal to the worst performing stock if the barrier is breached...and there's no capital protection below the barrier," Hampson said.

Elements get push

Merrill Lynch and Nuveen Investments have been busy pushing out their Elements exchange-traded notes.

The latest Elements to hit the market are a number of currency-linked products sold for Deutsche Bank AG, London Branch.

Deutsche issued $100 million of 0% Elements due Feb. 23, 2023 linked to the performance of the euro against the dollar on Friday. Those notes will pay par of $10 plus any increase in the performance of the euro versus the dollar, less an annual investor fee of 0.40% times the proportion of days elapsed, at maturity.

The securities have been approved for listing on the New York Stock Exchange under "ERE."

Another $100 million of 0% Elements due Feb. 23, 2023 are linked to the British pound/dollar exchange rate.

At maturity, investors will receive par plus any return on the exchange rate, less 0.25% per year and an annual investor fee of 0.4% times the proportion of days elapsed.

The securities have been approved for listing on the NYSE under "EGB."

Deutsche also priced a further $100 million of 0% Elements due Feb. 23, 2023 linked to the Australian dollar/U.S. dollar exchange rate. Payout at maturity will be par plus any return on the exchange rate, less 0.25% per year and an annual investor fee of 0.4% times the proportion of days elapsed.

Those securities will trade under the symbol "ADE."

The dollar/Canadian dollar rate is the underlying for yet another $100 million series of 0% Elements due Feb. 23, 2023.

Payout maturity will be par plus any return on the exchange rate, less 0.25% per year and an annual investor fee of 0.4% times the proportion of days elapsed.

All the securities additionally make distributions while outstanding based on the return on a deposit in the relevant currency.

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