JPMorgan’s $9.1 million notes on S&P MidCap 400 may outperform, adviser says

By Emma Trincal

New York, Oct. 24 – For investors who are unsure about what comes next after the current bear market, a recently priced note offers the potential to outperform in various market conditions, a financial adviser said. But if a vigorous bull market follows the current slump, the note could significantly underperform, another adviser warned.

JPMorgan Chase Financial Co. LLC priced $9.1 million of 0% capped buffered return enhanced notes due Nov. 16, 2023 linked to the S&P MidCap 400 index, according to a 424B2 filing with the Securities and Exchange Commission.

If the index gains, the payout at maturity will be par plus 150% of the return of the index capped at par plus 23.65%. The payout will be par if the index declines but by no more than the 10% buffer. Investors will lose 1% for every 1% that the index declines beyond the buffer.

Solid cap

“I like the note. You are looking at a short-term, very simple note with a good use of leverage. 24% on 13-months is an excellent return. And you even get a 10% buffer,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

The question any investor should ask themselves is whether being long the index fund would be a better option than holding the notes, he added.

“If I hold the index, there is no cap. I have all the upside potential, but I have no leverage and no downside protection. Then comes the key question: what is the likelihood of exceeding the cap?”

“Given that most economists anticipate a recession next year, probably in the second quarter or in the summer, I would guess the risk is less than 50%.

“I think you’re less likely to exceed the cap than not. If that’s right, then the cap is no longer an issue. It becomes clear that you’re better off with the note since you have the 10% buffer. A 10% downside protection is better than zero,” he said.

The leverage was also a factor. By leveraging the upside by 1.5 times up to a 23.65% cap, the issuer offered a maximum return of 21.7% on an annualized compounded basis. An index growth of 14.5% a year would achieve the optimal result. A leveraged upside with an index fund would come with a leveraged downside, a disadvantage compared to the asymmetrical leverage offered by the notes.

Hybrid asset class

Kunhardt then looked at the S&P MidCap 400 index. He noted that the S&P 500 index or the Russell 2000 index are much more commonly used as the underliers of structured notes than the mid-cap benchmark.

“The mid-cap 400 is a little tricky. A lot of advisers don’t consider mid-caps as an asset class. They go either small-caps or large-caps,” he said.

First there is “no consensus” on the real definition of mid-cap in terms of market capitalization, he said.

“Ask five people, you’ll get five different answers. Is it over $4 billion? $6 billion?”

Another issue was the very high correlation between mid-caps and the large-cap segment of the U.S. stock market.

“There is a big overlap between the S&P 500 and the S&P Midcap 400 if you go all the way down,” he said.

Salt and pepper

As a result, most advisers will use mid-cap stocks within the satellite allocation of their portfolio as opposed to the core, he noted.

“This may be the only caveat I can see with this note. The structure is very attractive, but its use in the portfolio is going to be limited. It will never be in your core,” he said.

Mid-caps may be used to reduce volatility when allocated to the small-cap allocation. Inversely allocating mid-cap equities to the large-cap bucket may help increase the volatility of the large-cap segment of the portfolio, he said.

Separately, an exposure to the S&P MidCap 400 index may serve the purpose of tilting an investment style by adding or reducing some factors such as value versus momentum for instance.

“It’s a little bit like salt and pepper. You can bias your portfolio by sprinkling some mid-caps,” he said.

Overall, positioning the notes in the portfolio would not be easy, he said.

“It’s more of the job of a portfolio manager but portfolio managers don’t like being pigeonholed. Midcaps is one of the three boxes with small and large caps. They don’t like to stick to asset allocation boxes or style boxes,” he said.

“That said, it’s a great note.”

Neutral or mildly bullish

Steven Foldes, wealth manager and founder of Evensky & Katz / Foldes Financial Wealth Management, said the structure of the notes did not meet his expectations.

“This note is for someone who is either neutral or moderately bullish, not for someone who is betting on a recovery and would want to participate in that recovery,” he said.

“We do like the buffer. Having a buffer on a short-term note is always nice because we don’t know what’s going to happen over the short-term and 13-months is short-term. Having 150% leverage is always a big plus.

“However, the cap is too low,” he said.

Low entry point

Foldes said he is very bullish given the current market downturn, which should be followed by a strong rebound.

“The S&P is already down 20% since the start of the year. We think that in 13 months, some of the clouds that have driven the market down will go away. The trend is already up,” he said.

The S&P 500 index hit a 52-week low on Oct. 13, at which point it was 27.5% off its Jan. 4 high. On Monday, the index closed 21.2% off its high after two strong sessions since Friday.

Positive short-term view

On the economic front, Foldes said “the recession is already here,” citing the two consecutive quarters of negative growth, which define a recession.

“There is already an economic slowdown. But the economy is moving forward. In 13 months, inflation should be under control; I would hope there would be some resolution to the war in Ukraine although you can’t be sure... It could go on a lot longer. Hopefully it won’t.”

Reshuffling the notes

Foldes would consider the notes but only if the cap was raised, or better, eliminated.

“If I had to redo that note, I would probably lengthen the term a bit, make it a two-year security. I would eliminate the buffer, which should free up more money to buy the options – and don’t forget, I’m also not getting the dividends – and I would eliminate the cap,” he said.

The S&P MidCap 400 index yields 1.87%.

“I would see what kind of leverage I could get. If the issuer cuts the leverage too much, I may keep the cap, but it would have to be much higher,” he said.

This adviser’s tolerance for a “higher” cap was also a function of the tenor.

“If it’s a two-year, though, I really don’t want a cap,” he said.

“In two years, it’s likely that the Fed will be reversing course by cutting interest rates, which would drive the markets up a lot.

“By extending the term, giving up the downside protection and reducing the leverage, I’m hoping to be able to eliminate the cap.

“That would be my mandate to the bank. I would then base my decision on the amount of leverage I can get.”

While Foldes would examine 1.3 or 1.4 times on a two-year uncapped note, a smaller multiple such as 1.1 times would not be an option, he said.

“I’m already giving up dividends,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes settled on Oct. 19.

The Cusip number is 48133NG28.

The fee is 0.22%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.