JPMorgan's 5%-7% autocallables on S&P 500, Vanguard fund seen as not the worst of worst-ofs

By Emma Trincal

New York, Jan. 7 - JPMorgan Chase & Co.'s 5% to 7% autocallable yield notes due Jan. 31, 2014 linked to the Vanguard Total Stock Market Index Fund exchange-traded fund and the S&P 500 index are a good example of an relatively attractive worst-of deal, sources said, pointing to 35% contingent downside protection, a short term and two highly correlated underlying assets.

The Vanguard Total Stock Market ETF has not been seen in a structured note before, sources also noted.

Data compiled by Prospect News since 2001 showed that this underlying has only been used three times before, each time by JPMorgan.

The notes will be called at par if each underlying component closes at or above its initial level on any of the quarterly call dates, according to an FWP filing with the Securities and Exchange Commission.

Interest is payable monthly. The exact coupon will be set at pricing.

A trigger event will occur if any component falls by more than 35% during the life of the notes.

The payout at maturity will be par unless a trigger event has occurred and either component finishes below its initial level, in which case investors will lose 1% for every 1% decline of the worse-performing component.

Two features of the structure made the product slightly less risky than the typical worst-of product, according to sources. The first was the high correlation between the Vanguard Total Stock Market index fund ETF and the S&P 500, and the second was the amount of protection over a short period of time.

High correlation

In a worst-of structure, the less correlated the underliers are, the greater the risk, they noted. That's because when correlation is low, the probability of a negative outcome is greater.

"It's not a bad note," said Carl Kunhardt, wealth adviser at Quest Capital Management, talking about the two underlyings.

"Those two are very correlated. The closer they act together, the more they behave like one."

The Vanguard Total Stock Market ETF seeks to track the Vanguard Total Return index, a broad U.S. equity index of 1,200 to 1,300 stocks representing 95% of the overall U.S. equity market.

"One reason for the high correlation is because the Vanguard is cap weighted and so the majority of the movement in the Vanguard is going to come from the large-cap [segment], which is what the S&P is. They are going to be very close in most market conditions," Kunhardt said.

Michael Kalscheur, financial adviser at Castle Wealth Advisors, agreed.

"These two are like 98% correlated. The options are so close to each other," he said.

"It doesn't really add that much risk to the offering, which is nice."

Not good enough

Despite the correlation advantage, Kunhardt said that he wouldn't use the notes.

"It's too complex," he said.

"I'm not saying it's a bad deal, especially for a worst of. It's a short-term note. JPMorgan is a good credit. There's a high correlation between the S&P and the Vanguard.

"I simply wouldn't use it because it's too complex. My benchmark is simple: if it takes more than two minutes to explain a deal to a client so that he can understand it, then there is no point in doing it.

"The only place I could possibly use it would be in a discretionary account. But even then I probably wouldn't do it because I manage my discretionary accounts pretty much the same way."

Kunhardt said that he could find other structured notes - "If I wait long enough" - that would give him "similar or better" returns.

"It's overly complicated for what it gives you," he said.

He mentioned the example of HSBC USA Inc.'s 0% digital plus barrier notes due Jan. 30, 2017 linked to the S&P 500 with a 27% to 33% minimum upside return and a 70% downside barrier.

"It may be a four-year, but the return is better for a similar level of protection and it's tied to only one index," he said.

He said that he recently saw other worst-of deals that were similar or better than the JPMorgan upcoming offering. The demand for these products is growing, he said, adding that he understood why.

Fixed-income replacement

"I've seen more worst-of products lately. People are buying them for the same reason they're buying structured notes in general: as a fixed-income replacement. Everybody realizes it's not an attractive market for fixed-income because you have valuations that are very high, rates at historical lows and an economic environment that's inflationary," Kunhardt said.

"Although we haven't seen inflation yet, as soon as inflation arises, bond valuations will be under pressure. Bill Gross has been saying that for three years. This is not rocket science.

"Products like worst-of are trying to replicate a fixed-income investment with equity.

"If you're worried about the market environment for fixed-income but still want to reduce the volatility of your equity portfolio, you have to find something else that's going to mitigate the risk. You're bullish on equity, but you're using some very broad equity exposure as a hedge to mitigate the volatility of your equity component.

"Structured notes today are bought to replace fixed income, not equity."

Solid protection

Kalscheur said that the notes' most appealing feature was the downside protection offered through the 65% barrier, although he would have "preferred" to see a buffer.

"I like the 35% contingent protection," he said.

"If you look at the mean average return and standard deviation of the S&P 500, the chances of breaking the 35% barrier are extremely low. Same for the Vanguard.

"If you do the back-of-the-envelope math, you find that this barrier offers a 99% probability of not being breached.

"It's not a buffer, but at least the barrier is big enough to give me some confidence - not assurance, but confidence that it will protect me for a year. I like that."

For Kalscheur, the notes are certainly not a bull play.

"You can't be very bullish on the market if you're willing to cap your returns at 5% to 7%," he said.

"For a person who is slightly pessimistic about the market and wants to hedge their bets a little bit, there are not a lot of places to go to in order to get 5% or 7% for a one-year. A lot of the securities which would give you that type of yield would add significant risk. At least here you have that barrier."

Income play

The notes "are not the perfect investment," he said.

"It's more of a trade. Chances are that you'll get called early in the first call date.

"I'm not a big fan of autocallables in general, although I see why people would add them to their portfolio as they have obvious benefits.

"Say you get called after three months. You make 1.25% to 1.75% in three months and then you put your money elsewhere. You're better off than with any money market or short-term bond fund. Nothing wrong with that," he said.

Kalscheur said that the notes may constitute an alternative source of income.

"For someone who already has exposure to high-yielding assets, such as dividend-paying stocks, preferred stocks or high-yield bonds, someone who is looking for yield without being super bullish, this deal would be a viable option."

He said that the JPMorgan credit exposure - "one of the best credits out there" - was an additional benefit to investors.

"The fees are high, much higher than I thought they would be on something like this. But it's also JPMorgan, and you can't get much better than that," he said.

The fees are expected to be 1.4%, according to the prospectus.

"It's not my first choice, but I can see how this would be a nice addition to a well-diversified conservative portfolio. It's not bad. Cut the fee in half and I'd be happy," he said.

J.P. Morgan Securities LLC is the agent for the upcoming deal, which is expected to price on Jan. 28 and settle on Jan. 31.

The Cusip number is 48126DRF8.

A rare underlying

The only three times the Vanguard Total Stock Market Index Fund ETF was used in a structured note since 2001 were the following:

• JPMorgan's $6.88 million of 6% autocallable yield notes due Sept. 5, 2013 linked to the ETF and the S&P 500. The notes priced on Aug. 30;

• JPMorgan's $1,415,000 of 8.7% reverse convertible notes due Oct. 1, 2012 linked to the ETF alone. The offering priced on Sept. 26, 2011; and

• JPMorgan's $1,545,000 of 9.7% reverse convertible notes due March 29, 2012 linked to the ETF alone. The pricing date was also Sept. 26, 2011.

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