JPMorgan’s $1 million capped digital notes on S&P MidCap 400 show novel, hybrid structure

By Emma Trincal

New York, Sept. 13 – JPMorgan Chase Financial Co. LLC’s $1 million of 0% capped buffered digital notes due Sept. 4, 2026 linked to the performance of the S&P MidCap 400 index introduced a relatively innovative payout, which combined the features of a digital and leveraged note.

If the index finishes at or above 114% of its initial level, the payout at maturity will be par plus a 14% digital return and then a 1.65% gain for each 1% increase past 114%, capped at par plus 50%, according to a 424B2 filing with the Securities and Exchange Commission.

The payout will be par plus the 14% digital return if the index finishes between its initial level and 114% of its initial level.

Investors will receive par if the index declines by no more than 15% and will lose 1% for each 1% decline beyond 15%.

Not a digital plus

“You get an accelerated return but above the 14% digital, not from initial price. So, it’s different from your typical leveraged note,” said a buysider.

It’s also different from the typical “digital plus” also known as uncapped digital, he noted.

With digital plus structures, investors receive the greater of the digital return and the index gain. But the index gain is calculated from the initial price.

Less than cash

The buysider objected to the minimum return in the notes.

“14% over three years isn’t much. That’s 4.45% a year compounded. You’re not even beating cash at these levels today,” he said.

A one-year T bill yields 5.43%, or nearly 100 basis points more, he noted.

“I would rather have a higher digital or less buffer in order to pay for it,” he said.

The partial leverage did not offer a lot of additional value.

“Having a digital plus with a higher digital would be just as attractive,” he said.

Another alternative would be to keep the 14% digital but on a shorter tenor.

For instance, the same digital amount on a two-year term would produce a 6.75% gain on an annualized compounded basis. Such return would surpass the 4.98% yield on the two-year Treasury.

Cap, leverage threshold

The typical digital plus offers another benefit: it removes the cap.

“The 50% maximum return you’re getting here is a bit low,” he said.

Another disadvantage compared to a digital plus or leveraged payout is the fact that the participation starts at 114%, a higher threshold than par.

He mentioned the following example.

With a point-to-point return of 24%, investors in the note would get 30.5% based on the 1.65% leverage applied above the 114% leverage threshold.

A traditional leveraged note enhancing the return from the initial price would generate a 39.6% gain at maturity assuming the same leverage multiple.

“The fact that you’re getting leverage only in excess of the digital is not that great. And then you have this 50% cap, which is not very high.

“I would look at it as a very conservative play with not a lot of upside potential,” he said.

Hedging cost

JPMorgan may have had some reasons to structure the product this way, he said.

One of them is the limited liquidity on the MidCap 400 index, making the cost of hedging higher.

“There’s a lot of large cap and small cap trading out there. But anytime we tried to put some mid cap, liquidity was just not there. Maybe that’s why they had to put all those bells and whistles to create a note that makes sense. Maybe the MidCap doesn’t structure very well with traditional terms,” he said.

Moving parts

Overall, though, this buysider said the note may not offer enough upside despite its innovative optics.

“It’s conservative. You have a 15% hard buffer, which is good. But I think there are other structures out there that are more competitive and easier to understand,” he said.

The innovative nature of the product could indeed be an obstacle for advisers trying to describe the terms to their clients.

“You have to explain the hard buffer; you have to explain the digital; you have to explain this particular type of digital with the leverage above 114%; and you have to explain the cap. That’s four pieces to explain. It makes it a fairly complex product,” he said.

Combo

Brady Beals, director, sales and product origination at Luma Financial Technologies, said the structure was relatively “novel.”

“I haven’t seen anything like that before,” he said.

“I have seen uncapped digitals but not the leverage above the digital. It’s a weird combination and I don’t know what the investor is trying to accomplish.”

Low expectations

Investors’ outlook had to be range bound given the payout, he noted.

“Since it’s capped at 50%, you’re shooting for a return between 14% and 50% on a three-year period. That’s moderately bullish,” he said.

“There are possibly better ways to accomplish this.

“You could do an out-of-the money digital when you get paid if the index goes up above a certain level.

“You could cut the buffer, make the leverage higher or raise the cap.”

The note was probably the result of a client’s request focusing on the amount of minimum return.

“Someone may have said they would be happy with a 14% minimum,” he said.

“But honestly, 14% over three years is not great especially if your total gain is capped at 50%.

“It looks like a bad hybrid bet.

“You’d probably get a better outcome with a pure leverage play.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes settled on Sept. 7.

The Cusip number is 48134AAY1.

The fee is 0.45%.

© 2015 Prospect News.
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