JPMorgan’s relative value notes linked to basket versus S&P 500 offer specific sector calls

By Emma Trincal

New York, Jan. 22 – JPMorgan Chase & Co.’s 0% relative value notes due Feb. 10, 2016 linked to the capped upside return of a basket of indexes and the downside return of the S&P 500 index enable investors to pick three sectors they believe will outperform the S&P 500 and gain from the relative value, sources said.

The equally weighted basket consists of the Financial Select Sector index, the Health Care Select Sector index and the Consumer Discretionary Select Sector index, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 1.155 times any basket gain, up to a maximum return of 23.1%. Investors will also be exposed to any decline in the S&P 500.

“The upside is capped, but you have full downside exposure to the S&P, and that’s the scary thing,” said Steve Doucette, financial adviser at Proctor Financial. “You have to be a strong believer that these three sectors will outperform the benchmark. You’re long the S&P on the downside. If the S&P is down, chances are the three sectors will be down too.”

Sector picks

The three sector components of the basket represent slightly more than a 40% weight in the S&P 500, with a 16% weighting for the financial sector, a 15% weighting for the health-care sector and a 12% weighting for the consumer discretionary sector.

“You make a sector call. You’re betting that 40% of the index will outperform going forward,” Doucette said.

While the three picks looked “reasonable” based on their fundamentals, “the hard part” was the forecast.

“There’s no technology in your basket, no materials, no industrials or even consumer defensive,” he said.

“You’re not going to have any sector rotation for a year. So you have to be pretty sure that those are the very best sectors because that’s how you get paid.

“Problem is one year is a very short time. Predictions are tricky. You don’t really know what’s going to happen with the market this year much less with three sectors of the market.”

Investors in the notes make a relative value but also a directional bet on three sectors.

“If you do your due diligence and have the conviction, it may make sense. But you have to expect those sectors to outperform, otherwise you’re subjecting yourself to be long the index on the downside without any protection. That’s what it boils down to,” he said.

Bullish

One attractive aspect of the structure was the cap.

“Obviously you have to be bullish on the benchmark. You don’t want to see your upside offset by the index decline,” he said.

“It’s by giving you negative exposure to the S&P that they’re able to offer the leverage with a very decent cap.

“It’s more than decent actually. Your basket has to be up 20% for you to hit the cap. That’s 20% in one year. I don’t think I’d ever attempt to be that bullish on any sector of the S&P.”

Good choices

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the deal offered “an interesting structure” and that he was bullish on the three sectors constituting the basket.

“There are nine sectors in the S&P 500, and they picked three representations of the index. I like those three sectors very much,” he said.

Investors in the notes should have a positive bias for the three sectors, which make for around 40% of the index.

“I don’t believe not having the balance – the other 60% – is going to drag down performance very much,” he said.

“Those are three very strong sectors.

“Health care continues to improve. Consumer discretionary also makes sense. With consumer confidence at a higher level and hopefully, the improvement in the economy showing more consistent growth, with reduced inflationary pressures and lower oil prices, this sector is likely to do well as investors will become more comfortable spending money.

“Finally the outlook for financial stocks is good too. The refinancing market is starting to improve due to very low interest rates. Financial institutions will benefit from it.”

Downside diversified

While the notes offer no downside protection, Medeiros said that having downside exposure to the index was a way to mitigate risk since the S&P 500 is much more diversified than some of its parts, such as the basket itself.

“If the three sectors go down, the S&P is unlikely to go down as much,” he said.

“Besides, the negative performance of some sectors can be beneficial to some of the sectors in the basket. “For instance, a decline of the energy sector due to falling oil prices is going to boost consumption by increasing consumers’ real income. It sort of self-corrects. Low oil prices put more money in consumers’ pockets. It’s a positive for the consumer discretionary sector. It’s a plus for the basket.”

Relative value and value

On the upside, having exposure to only three sectors and not the other six was not seen as “dragging down” the basket return all that much.

“If the basket return is positive but ends up underperforming the S&P, I don’t think you’re going to lag behind the index that much,” he said.

Picking the right sectors can make a big difference in terms of returns, he noted.

In 2014, the S&P 500 index rose by 13.70%. Meanwhile, the returns for the health-care, financials and consumer discretionary sectors were 25.35%, 15.20% and 9.68%, respectively. The average performance of 16.75% would have generated a 19.35% basket return after leverage, which is nearly 6% above the index.

In 2013, the average of the three basket components also outperformed the S&P 500. The outperformance was so strong, however, that noteholders would have been penalized by the cap despite making the correct sector calls.

The benchmark posted a 32.4% return in 2013. Gains for consumer discretionary, health care and financials ended up much higher at 43%, 41.46% and 35.63%, respectively, or a 40% average. After applying the leverage, the return for the basket would have been 46.25%, but with the cap investors would have only earned 23.1%, underperforming the market by nearly 10 points.

The notes (Cusip: 48127D6T0) will price on Friday and settle on Jan. 28.

J.P. Morgan Securities LLC is the underwriter.

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