JPMorgan’s callable range accrual notes linked to indexes, rates have unusual hybrid structure

By Emma Trincal

New York, Aug. 23 – JPMorgan Chase Financial Co. LLC’s callable range accrual notes due Sept. 3, 2024 linked to the 30-year U.S. dollar ICE swap rate, the two-year U.S. dollar ICE swap rate, the S&P 500 index and the Russell 2000 index exemplify the lengths to which issuers will go to boost coupons, sources said.

Some may refer to the yield-enhancing techniques as “bells and whistles,” but innovation seems required to generate more return in this low-rate and low-volatility environment, they said.

Interest will be fixed at 7% for the first year, according to a 424B2 filing with the Securities and Exchange Commission.

After that, it will accrue at eight times the spread of the 30-year ICE swap rate over the two-year ICE swap rate for each day that the indexes close at or above the 65% minimum index level, up to a maximum of 8% per year. Interest is payable quarterly and cannot be less than zero.

The notes will be callable at par on any quarterly redemption date after one year.

The payout at maturity will be par unless either index finishes below its 65% barrier level, in which case investors will be fully exposed to the decline of the worse-performing index.

Problematic allocation

“It’s not the worst thing I’ve seen,” a market participant said.

“The 65% barrier is not a bad barrier. And with the worst of, you get that 7%.

“I wouldn’t buy the paper, but I can see why somebody would.”

One drawback, he explained, is the variety of underliers belonging to different asset classes.

“The problem really is, how do you classify it? It’s got so many bells and whistles ... I wouldn’t know in which part of the portfolio to put it.”

Downside

The first-year rate is “attractive,” and the odds of getting a competitive yield are good in his view.

“I think the curve will be positively sloped,” he said, referring to the spread of the 30-year and two-year ICE swap rates.

But the notes would not fit a fixed-income replacement strategy given the fact that principal is exposed to too much risk, he added.

“The barrier seems high to me. I’m more concerned about the principal than the interest.”

Market risk is even more of a concern in light of current valuations in the U.S. stock market.

“The volatility used to price up the coupon is at its lowest. You have to ask yourself if you’re getting paid for that risk.”

Bear threat

The risk of a major bear market is a real possibility as the U.S. bull cycle is in its eighth year.

“I’m just picking up the worst possible time in history to be exposed to a market correction,” he said.

“Investors are so desperate for yield that they’re willing to accept a coupon based on a historically low volatility.

“Issuers are struggling with ways to come up with acceptable coupons.

“They’re throwing a lot of different things in the product. It just goes to show to what length they have to go to make the coupon work in this environment.”

ICE swap spread

An industry source had a different view regarding the barrier, seeing the risk on the limited return.

He first noted the relative novelty of the product.

“While I have seen hybrid range accrual [notes] with an equity component, having two indices in a worst-of is a little bit different,” he said.

He compared the fixed rate with a floating rate, assuming the equity conditions are met at all times.

“The 7% teaser rate seems attractive, but I would first want to know where we are right now, what’s the spread,” he said.

The 30-year U.S. dollar ICE swap rate is 2.43%, and the two-year rate is 1.58%, which represents a current spread of 85 basis points. With eight times leverage, the floating coupon would be 6.8% now, which is close to but slightly lower than the guaranteed rate.

Best and reasonable

“That’s assuming that the indices won’t drop below the 65% barrier on any day. But I think it’s fair to say that this is the assumption that any buyer of the notes would be making. They’re counting on the eight times the spread,” he said.

This reasoning explained why the downside risk at maturity is this source’s main concern.

“The 65% barrier on equities is OK. I’ve seen higher equity barriers,” he noted.

However, for investors who believe that the curve will steepen, the 8% cap may be too low, he added.

“They give you a little bit of upside. But the curve, if not historically flat, is more skewed toward being flat, and you could easily blow through that cap if the curve were to steepen, which is more likely based on where we are now in absolute flatness.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price on Tuesday and settle on Sept. 1.

The Cusip number is 46647MNB5.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.