JPMorgan prices $234.65 million tied to new index, the Enhanced Beta Select Backwardation

By Emma Trincal

New York, Nov. 27 - JPMorgan priced the second largest deal this year with an offering of nearly $235 million tied to a new proprietary index designed to enhance the roll yield of the commodities futures contracts underlying the index, according to data compiled by Prospect News and a 424B2 filing with the Securities and Exchange Commission.

JPMorgan Chase & Co. priced $234.65 million of 0% return notes due Nov. 27, 2018 linked to the JPMorgan Enhanced Beta Select Backwardation Alternative Benchmark Total Return index, according to the prospectus. The index is a notional dynamic index that tracks the return of seven weighted synthetic excess return subindexes that reference futures contracts on 22 specified commodities plus the return on three-month Treasury bills.

"It's a quarter-of-a-billion. It's quite a big number," said Tom May, partner at Catley Lakeman Securities.

"It looks like someone just wanted to be clever in choosing the right commodities contracts.

"It could be one big institution deciding that they want to better allocate their commodity assets. Or it could be a private bank deal. They would sell it to clients or hold it on their behalf."

Dynamic roll

The index is composed of commodities futures contracts. At delivery, contracts within an index always need to be rolled rather than delivered, with the nearby contracts selling while longer-dated contracts are being purchased.

"Backwardation" refers to the situation where the futures contracts for a commodity with a delivery month further in time have a lower price than shorter-dated contracts. Backwardation generates a positive roll yield for investors as the front month can be sold at a higher price than the price at which the further-dated contract is being bought. The opposite situation - when the yield is negative because it costs more to roll the expiring contracts - is called "contango."

The notes have a simple "tracker" structure in which investors at maturity get paid the return of the underlying index minus a fee of 0.85% per annum.

The index rebalances monthly, which is when each constituent is assigned a weight equal to the most recently published weight of the Dow Jones-UBS commodity sub-index that references the underlying commodity associated with that constituent, according to the prospectus.

"You get exposure to only commodities that are in backwardation," said a market participant.

The way the index seeks backwardation is by selecting on a weekly basis only two or three commodities among the 22, which show the highest degree of backwardation or alternatively, the lowest degree of contango, according to the prospectus.

Contrarian bet

"This index is not something that's performing outstandingly," said the market participant.

"However, in comparison with the Dow Jones UBS commodity index, it's performing quite well, simply because the Dow Jones UBS benchmark has done so poorly," he added based on the back-tested performance of JPMorgan's relatively new index, which was established on Aug. 27.

So far this year, the JPMorgan Enhanced Beta Select Backwardation index has outperformed the Dow Jones UBS Commodity index by 5.8%, he said.

The Dow Jones UBS Commodity index is down 11% this year and has lost nearly 14% over the past 12 months.

The size of the deal was also noteworthy.

It was the second after Bank of America Corp.'s $284.49 million of 0% Leveraged Index Return Notes due June 29, 2018 linked to the Dow Jones industrial average, which priced at the end of June, according to data compiled by Prospect News.

The data based on U.S. registered notes does not include exchange-traded notes. It also does not take into account lightly structured fixed-income notes such as step-up notes, step-down notes, fixed-to-floating notes and capped floaters.

"For a sum like that, it seems like it should be an institutional," this market participant said.

The investment did not reflect mainstream sentiment for commodities, he said.

"Everybody has been underweight commodities for the past year or so. First, because there is enough supply. And second you had the outflows out of gold.

"Natural gas has always been difficult to invest in, in part because of this contango problematic, which makes you lose a large part of performance.

"So you have two out of 22 commodities that are difficult to invest in. Oil was flattish. Volatility is low. Generally speaking, commodities have not been a performing asset class.

"It's understandable that most people don't want to invest in commodities at this point. But some people like to be contrarian and they want to place a bet on the least performing asset class of the year.

"If you want commodity exposure, there is no reason to choose the Dow Jones UBS as the benchmark and the same is true for the S&P GSCI commodity index.

"They're all front month indices where you have the problematic contango. This one here at least allows you to move away from contango issues that drag the performance of your portfolio and to focus on commodities in backwardation."

Some independent index providers have created dynamic versions of their broad-based commodity benchmarks. It is the case with S&P Dow Jones Indices, which launched three years ago the S&P GSCI Dynamic Roll index, also based on a dynamic rolling strategy designed to limit the negative impact of contango.

Other index providers and banks have come up with their own version of dynamic commodity indexes designed to achieve the same results.

Proprietary indexes

The JPMorgan Enhanced Beta Select Backwardation Alternative Benchmark Total Return index however was not designed by an independent, third-party index provider, noted May.

"It's a proprietary index," he said.

"In general, I have no problem with the concept of a proprietary index as long as the cost is transparent within the index. You don't want investors having to guess the amount that the bank is taking out.

"If it enables an investor to gain exposure to an asset class which otherwise would not be possible to gain access to, I don't think it's a bad idea at all.

"I'm not familiar with this index but we've seen unfortunately some proprietary indexes built for the purpose of the distributor rather than the investor.

"Investors need to make sure they understand the investment rationale behind the model and that it's just not another way for the issuer to sell something."

In addition, the value of a proprietary index, sometimes referred to as a "black box," is based on the soundness of the rules that support the algorithmic model, he said.

"With all those proprietary indexes, the difficulty in assessing them lies in the assumptions used in the methodology.

"The index is as good as the assumptions behind the strategy, and a lot of its success depends on whether these assumptions hold or not.

"If it works, it will outperform. But sometimes, the assumption turns out not to happen.

"The models built around subprime debt for instance fell out bad. The models were wrong.

"Even with this index where the rule appears simple - you pick the commodities in backwardation, you can always have unexpected events.

"Anytime you build a model around rules and assumptions, there is risk. You always have the risk when you have so many moving parts," he said.

The notes (Cusip: 48126NTE7) priced on Nov. 22.

J.P. Morgan Securities LLC was the agent.

The index performance is reported by Bloomberg LP under the ticker symbol "JBACDJSE <Index>".

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