JPMorgan’s contingent income autocall tied to Apple show step-up call threshold

By Emma Trincal

New York, April 21 – JPMorgan Chase Financial Co. LLC’s contingent income autocallable securities due April 2020 linked to the stock price of Apple Inc offer investors a chance to earn a coupon each quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The structure includes an added feature designed to extend the length of time during which noteholders may collect their income, called a “step-up redemption threshold price” feature in the prospectus.

But Future Value Consultants’ stress-test report showed the limits of the benefits associated with this feature.

“Despite the step-up, the odds are still very high that you’ll be called sooner rather than later, said Suzi Hampson, structured products analyst at Future Value Consultants.

The notes will be called at par of $10 plus an 8.75% annual contingent coupon if Apple shares close at or above the threshold redemption price on any of the first 11 determination dates. The threshold redemption price will be 105% of the initial stock price for the first four determination dates; it will be 110% of the initial stock price for the fifth through eighth determination dates; and it will be 115% of the initial stock price for the ninth through 11th determination dates.

The contingent coupon at an annualized rate of 8.75% gets paid on a quarterly determination date if Apple shares close at or above a downside threshold level, which is 80% of the initial price.

The barrier at maturity is also set at 80%.

Uncommon

“The autocall level changes in this note, which is not very common at least in the U.S.,” said Hampson.

The notes start higher than par at a redemption threshold of 105% and increase progressively every four quarters to 110% first and then 115%.

In the U.K. the opposite has been observed.

“We have the step-down, which increases the chance of being called,” she said.

What she has observed before was the existence of fixed call levels set higher than par.

But a higher threshold, which progressively increases is not very common, she said.

One moving piece

“If the stock price increases by more than 5%, it will kick out. Otherwise you stay in and get another chance to collect the coupon,” she said.

“You want to stay invested so you can collect as much income as possible quarter after quarter.”

It is easier to get the coupon set at the downside threshold than it is to get called.

“The coupon barrier stays at 80%. It doesn’t change. It’s the kick out level that does,” she said.

Market risk

The step-up comes with some disadvantages however.

“Potentially the risk level will be increased because when you kick out, you don’t have any risk anymore. You’re finished,” she said.

“Since the whole idea of the step-up is to keep you in the product longer, you are likely to be subject to more market risk.”

On the other hand reinvestment risk should be lower.

“Each time it goes up, it reduces your chances of being called,” she said. “This is a way to increase your potential income. You’re hoping that you won’t have to reinvest your money elsewhere.”

The best scenario for noteholders would be if the stock price stayed above the 80% coupon barrier and below the autocallable level.

“That would be ideal: you collect until the end,” she said.

The stress-test however showed that such a scenario was improbable.

Not a non-call

Hampson compared the step-up with a call protection, a feature sometimes found with a traditional autocallable note.

A call protection blocks an early redemption during an initial period of time usually for the first six or 12 months.

Both a call protection and the step-up are designed to give investors more chances to receive their return, she said.

In reality the two mechanisms are very different.

“The step-up redemption doesn’t do a whole lot to protect you in the short term, which is when you’re the most likely to be called,” she said.

“A call protection is a much better guarantee for you to get e a steady return.”

Average payoff

She used one of the sections included in Future Value Consultants’ stress-report to illustrate her point: the scorecard.

This table is made of different mutually exclusive outcomes of product performance. In this case the outcomes are the probabilities of calls at the 12 quarterly dates of “call points.” The Monte Carlo simulation assigns for each outcome a probability as well as an average payoff.

Payoffs are easy to predict: if the notes are automatically called on the first quarterly date, the payout will be 102.2%, which is based on the annualized rate of return of the coupon.

More “telling,” she said was the “very high” probability of being called after only three months. The scorecard assigns a 32.42% probability to this outcome.

Short lived

The probability of being called on the second call date (six months after inception) is 13.90%, according to the scorecard. During the first six months, investors will be called nearly one time out of two. At the end of the ninth month, the probability slowly rises to 54%.

“If the idea is: I want to stay longer, there is a threshold that goes up progressively, great! Except that the level goes up after one year and then you have a pretty small chance of being called anyway,” she said.

“It’s pretty much the opposite of having a one-year non-call if you think about it.

“Statistically, people do get called early with these products. A non-call gives you a better protection. It kicks in right away.

“At the same time, a one-year non-call would probably pay a lower coupon because you have the guarantee that you won’t be called during that time.”

If investors must pay attention to the call risk, market risk should also be considered.

According to the scorecard, which is a forward-looking simulation, investors in this product incur a 19.5% chance of losing principal with an average loss of 33.20%.

Back in time

The backtested investor scorecard shows a much brighter picture skewed by the long bull market cycle now on its eighth year, she said.

The backtested scorecard covers three time horizons: five, 10 and 15 years.

In the last five and 10 years, the probabilities of losses are zero. In the past 15 years however, which include the bear market of 2007-09, the odds of losing money were still low at 3.70%. But the severity of the bear market made the average loss equal to approximately a third of one’s initial investment.

Hampson however concluded that early redemption should be the most important issue to consider for investors.

“You should worry about capital losses but you’re more likely to be out of the product, finishing on earlier than you’d like it,” she said.

“As long as you understand this risk and that you are aware of the disproportionate amount of fee you may incur if you get called after three months, this is a decent deal for income investors.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent. Morgan Stanley Wealth Management is a dealer.

The notes (Cusip: 48129F358) will settle on Wednesday.

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