JPMorgan's contingent coupon CDs tied to 10 stocks offer annual income play to moderate bulls

By Emma Trincal

New York, Feb. 11 - JPMorgan Chase Bank, NA's planned contingent coupon certificates of deposit based on a stock basket give moderately bullish investors an income alternative to bullet CDs with a potentially attractive upside, a market source said.

The CDs will be due Feb. 26, 2016, according to a term sheet.

The equally weighted basket includes Alcoa Inc., Abbott Laboratories, Amazon.com, Inc., CVS Caremark Corp., Costco Wholesale Corp., General Electric Co., Microsoft Corp., Newmont Mining Corp., Verizon Communications Inc. and Wells Fargo & Co.

The notes will pay interest in February of each year. The coupon will be the sum of the weighted returns of the basket stocks, subject to a floor of at least 0.75%. The return of each basket stock will be subject to a cap of at least 8% in each interest period. The exact floor and cap will be set at pricing.

The payout at maturity will be par.

Beating the bullets

"This minimum coupon is very popular among investors. Each year, you can expect to make between 0.75% and 8%. And it's [Federal Deposit Insurance Corp.]-insured," the market source said.

Income alternative

According to the term sheet, investors may run the risk of not earning more than 0.75% coupon payments on years when the average return of the basket stocks declines from the inception date.

But with a 0.75% minimum coupon, investors are better off holding the structured CDs than a bullet CD, this source said.

"If you think rates are going to be hanging out in this low interest rates environment, it's a great alternative to a traditional CD," this market source said.

"You have the opportunity to outperform a six-year bullet north of 500 basis points," he said based on his five-year CD rate estimate of 2.65%.

Moderate bulls

The term sheet describes the existence of an 8% annual cap as another risk to consider.

"The appreciation potential of the CDs is limited by the 8% coupon cap," even if the reference stocks generate a much higher return than the cap, according to the document.

"You cannot be extremely bullish on the stocks, otherwise you wouldn't want the 8% cap," the market source said. "But if you're just moderately bullish and think the basket is not going to go up too much in six years, then this gives you an opportunity to lock in a minimum coupon with an attractive upside potential."

From inception

The performance of the basket is measured each year in February from the inception date.

"As time goes on, each year, if you believe that stocks are going to go up, then starting from inception is a better calculation method than year-over-year. Going from inception gives you a better performance because stocks over time are expected to go up," the source said.

This source gave possible payout examples.

The basket could be up 10% for instance at the end of the first year, and investors would only get 8%. But the basket decline could be significant, and investors would still earn a 0.75% coupon.

"Of course, you could have a situation where at the end of the first year, the average of the stocks is up 30%. You only make 8%. But then, imagine that the market is flat at the end of year two. You're going to get your 8% then given that performance is calculated from the initial date and that you're averaging a very good year with a flat year. Now imagine that there is a massive crash in the third year. Your basket is down 20%. You still get your 0.75%," he said.

Few contingent coupon deals

Investors are attracted to minimum interest payouts when buying structured products whether the products are notes or CDs, sources said.

JPMorgan offers minimum annual coupons in its CD offerings on a fairly consistent basis, according to data available in Prospect News. Other CD issuers such as HSBC Bank USA, NA, Wells Fargo Bank, NA and SunTrust Bank offer this feature as well but not necessarily as often, according to the data.

Investors looking for a contingent coupon often have to look at structured notes as well, with issuers such as Credit Suisse, Nassau Branch, UBS AG and Morgan Stanley delivering those options in their products from time to time.

Instead of a contingent coupon, some CD offerings offer a floor of zero for the coupon along with a mechanism in which the return of each basket stock will be subject to a floor of a negative percentage in order to limit the overall decline.

Rare baskets

Another particularity of this CD offering is the use of a basket of stocks as the underlying.

"Most of the time, CDs are getting done around indexes, not baskets of stocks," said a New York sellsider at a bank.

"That's because retail clients prefer passive investing rather than having to do stock picking," he said, adding that there is another reason: "Banks are looking for structures that are not too complex and that can be easily hedged. They want to avoid correlation risk. So you see single stocks in reverse convertibles and you see indexes in notes and CDs. But overall, very few baskets."

"It's a correlation dispersion trade," said the market participant, talking about the stock basket used by JPMorgan for its CDs. "You don't see 10 bank stocks in there. It's more like one or two tech stocks, one or two health care. It's more sector-driven."

The CDs are expected to price Feb. 23 and settle Feb. 26.

J.P. Morgan Securities Inc. is the agent. Incapital LLC is the distributor.

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