JPMorgan's leveraged notes tied to iShares Russell 2000 offer 'good mix of upside and downside'

By Emma Trincal

New York, May 28 - JPMorgan Chase & Co.'s planned 0% buffered return enhanced notes due Dec. 9, 2011 based on the iShares Russell 2000 index fund give investors an opportunity to outperform the small-cap index with an attractive risk-reward profile, said Tim Mortimer, managing director of Future Value Consultants.

"Accelerated growth products have become a staple of medium risk in the U.S. structured products market," said Mortimer. "This one offers a good mix of upside and downside."

The payout at maturity will be par plus double any fund gain, up to a maximum return of 19.25% to 24.25%, according to an FWP filing with the Securities and Exchange Commission. The exact cap will be set at pricing.

Investors will receive par if the shares fall by up to 15% and will lose 1% for every 1% decline beyond 15%.

The iShares Russell 2000 index fund is an exchange-traded fund that seeks to track the small capitalization sector of the U.S. equity market, as measured by the Russell 2000 index.

Underlying volatility

"With smaller cap, you expect high volatility," said Mortimer who compared the historical volatility of the Russell 2000 index (40%) with that of the S&P 500 index (25%).

"When you enter a bull market, small stocks always perform well. These notes should be attractive to investors who are trying to catch the recovery in the cycle. If the market is going up, small caps always outperform large caps," said Mortimer.

Performance potential

While returns are capped, Mortimer said that the maximum return is set at a high enough level to allow investors to potentially outperform the index because of the leverage.

"The note can outperform the fund with even moderate index gains," said Mortimer.

The notes offer two times leverage with a cap that can be set as high as 24.25%. Depending on the final cap determined at pricing, the return is the equivalent of a 12.37% to 15.46% annualized gain, said Mortimer.

"It's not a bad cap. With the double gear, the full potential return at 24% can be achieved with an index up only 12% in a year-and-a-half or 8% per year. It doesn't take much to hit the maximum return," said Mortimer.

"These notes could serve two different purposes in a portfolio: it could be a mildly bullish bet on a modest growth of the small-cap sector; or someone may use it as a way to diversify a portfolio that is largely exposed to the S&P 500."

15% buffer

As with most growth products, only a portion of the principal is protected. In this case, investors get principal protection at maturity against up to a decline of 15% in the final share price of the fund, according to the prospectus.

"It's only a 15% buffer. But if you put too much of a buffer, you would have no upside left," said Mortimer.

"The 15% buffer seems reasonable here in relation to the cap. You could have a 30% decline and you would lose half of it," he said.

Riskmap - a Future Value Consultants rating that measures the risk associated with a product on a scale from zero to 10 - is 4.66 for this product.

The riskmap is higher than most principal-protected products rated by Future Value Consultants but remains average overall.

"The buffer in my view does quite a good job," said Mortimer.

"The notes are for someone who has limited exposure to small cap and who is willing to take a little bit more risk," he added.

Good trade-off

A reading of the return rating gives an even clearer view of the risk-adjusted return of the notes, on a scale of zero to 10.

Future Value Consultants calculates the return score using a Monte Carlo simulations model, which it also uses to collect information for its probability tables of return outcomes. Both the return rating and the return probability tables are calculated based on the historical volatility of the underlying. Other factors in the model include dividends and interest rates.

The product has a 5.69 return score.

"This product does a good job at offering good upside potential while limiting the downside with the 15% buffer," said Mortimer.

"The buffer will not cover all the downside, but it's probably a healthy buffer. It gives you a chance to do 25% in one-and-a-half year," he noted.

In addition, Mortimer said that the dispersion of probabilities between gains and losses was attractive.

Investors have a 52% probability to earn an annualized return of 10% to 15%. The probability to do more is null as the gains are capped.

On the downside, investors have a 23% risk of losing 5% or more of their principal, according to the firm's research report.

"The risk of losing beyond the 15% buffer is mitigated by a pretty good upside of 24%. It's not a bad performance," he said.

"You have twice the chance of getting some upside than getting some downside. Any product that has much better chance of upside than the downside offers a good trade-off," Mortimer said.

He noted that some products showed downside probabilities almost equal to the probability of upside.

"This one has its best bucket on the upside with 52%. It's a pretty good profile," he said.

Overall and value

Simplicity rating is Future Value Consultants' opinion on how simple and easy to understand a structure is. On a scale of zero to 10, this product scores 8.50.

The combination of good return and simplicity ratings give this product an attractive overall rating of 5.67 in relation to other recently rated products in various categories, said Mortimer.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and risk-return profile. It's an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

"The overall rating is average based on all other products. It's a reasonable score due to the return and simplicity scores as well as the riskmap. It's not based on the S&P 500 index, and it's not based on a stock. You get a good risk-adjusted return," he said.

What may have dragged down the overall score is the low value rating of 4.23.

Value rating on a scale of zero to 10 is Future Value Consultants' measures of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

"This is not a low value score. It's actually average. But given the recent market movements in the past few days, it is possible that the score may be updated at a higher level when we finalize our ratings," he said.

With the rising volatility, the option price for the Russell 2000 index may have gone up, which would give the product a higher value score from the day the report was completed, he explained.

The notes will price on June 4 and settle on June 9.

J.P. Morgan Securities Inc. is the agent.

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