JPMorgan’s variable income CDs on High Yield ETF Volatility offer alternative to regular CDs

By Emma Trincal

New York, June 17 – JPMorgan Chase Bank, NA’s variable annual income certificates of deposit due June 30, 2021 linked to the J.P. Morgan High Yield ETF Volatility Target Index 3% give investors a chance to earn competitive income relative to a traditional CD, but one aspect of the coupon rate calculation requires interest rates to rise enough in order to sustain the yield over time, sources said.

Interest is payable annually at a rate equal to the index return multiplied by the index factor, with a minimum coupon of at least 0.75%. The exact minimum coupon will be set at pricing.

The index factor is the following fraction: one divided by the number of years of paid coupons including the current year.

The payout at maturity will be par plus the last coupon payment.

The level of the index reflects the deduction of a fee of 1% per year.

Higher yield

“This is a trade for somebody looking for an alternative to a plain-vanilla CD which would have a minimum return. It’s market-guaranteed like any other CD. It’s an income-oriented product,” an industry source said.

“The ETF is the Pimco Total Return. It spits out high-yield dividend. The structure creates a payout that allowed the customer to earn between 75 basis points and somewhere between 5% and 6%.”

Proprietary index

The J.P. Morgan High Yield ETF Volatility Target Index 3% is a notional dynamic strategy that tracks the return of the Pimco 0-5 Year High Yield Corporate Bond Index exchange-traded fund in excess of a synthetic borrowing cost component accruing interest at Libor while targeting a specific volatility on a daily basis, according to a term sheet.

The index was created on Aug. 16, 2011 by J.P. Morgan Securities LLC, the calculation agent.

The index level was 116.62 on May 30, according to the term sheet.

The variable yield has the potential to “beat” Treasuries, this industry source said.

“On a seven-year Treasury, you’re looking at 2.25%. A seven-year brokered CD is about 2%. Here you get only 75 basis points in fixed return, but you also have the potential to beat Treasuries and traditional CDs. Your goal is to obtain a much higher yield. And while there is no guarantee of course, that’s the risk you take. You want the enhanced beta,” he said.

The risk section of the term sheet, however, disclosed a risk caused by the calculation method of the coupon as the index factor may cut the return.

“[The impact of the index factor] is to reduce the cumulative index return over time,” the term sheet warned.

“As a result, an earlier increase in the index will result in a higher coupon payment than a single increase in the index later in the term, unless the later increase is sufficient to offset the negative effect of the index factor.”

Index factor

A market participant illustrated the index factor risk with an example.

“The assumption behind this trade is that the rise in interest rates will compensate you for the negative impact of the index factor. But it may or may not happen,” he said.

“Let’s pick an example. Assume that on the first year, the index is up 5%. Your index factor is one since you’re on year one, so you get 5% times one. That’s your 5% in full that you get,” he said.

“On the second year, the return is also 5%. Your index factor is now 0.5. That gives you a return of half of 5%, which is 2.5%.

“Unless the interest continuously rises, this structure pays you less and less the longer you go out.

“If on year seven, the return is still 5%, you’re only getting a seventh of that, or 0.71%.”

Interest rates will have to rise for the coupon amount to sustain its value, he said.

“Let’s imagine a scenario of interest rates going up,” he added.

“First year it’s 5%. You get 5%. On the second year, it goes to 10%. You keep your 5%. On the third year, rates rise to 15%. You still make 5%.

“If the structure was a digital at 5%, you would feel capped. With this, you’re not capped, but rates have to consistently go up for you to maintain your income.”

Not a digital

Complexity is another concern, the market participant said.

“This structure helps you benefit from a rising interest rates environment. It’s an interesting deal. But it sounds a little bit complicated for the customer,” he said.

“You get the performance of the index times this index factor.

“It may have been easier to understand it with a digital structure. For instance, if the index is up, you get the return of the index. If it’s negative but above a certain level, you get a digital payment.

“It’s more expensive to price a digital. But for a client, it’s much easier to understand what they’re going to get.”

The structuring was facilitated by the volatility target component of the underlying index, the industry source said.

Volatility target and pricing

“They move between the ETF level and the 3% volatility target. With a 3% volatility target, you don’t get the spicy return, but that’s not what it’s designed for. It was designed for someone who would be looking to get minimum return close to what a typical brokered CD could get with the ability to have some upside,” the industry source said.

“They used a volatility target when they put together the index. The trade wouldn’t work without the controlled vol.

“Rates are so low ... you would have had to do a call spread or some averaging.”

The volatility target, which is the main feature of the underlying proprietary index, is an efficient tool to reduce the cost of the options used to structure the CD, agreed the market participant.

“There is no doubt that without the volatility target, the structure would be super expensive. It would be undoable. The volatility target helps the issuer control the pace of volatility spikes,” he said.

“You’re buying calls, and you know what the volatility level is going to be. It takes the variable out of the traders’ book. Volatility is the biggest variable in options. Now you don’t have to worry about it. It cheapens the options significantly to the point where you can build the structure. The target vol is a way to eliminate one of the most challenging variables in hedging.”

The first CDs linked to the J.P. Morgan High Yield ETF Volatility Target Index 3% were launched in April, followed by a second offering in May. The upcoming offering, set to price on June 25, will be the third.

“Chances are they’ll be able to do one once a month since the notional has increased,” the industry source said.

J.P. Morgan Securities LLC is the agent. Incapital LLC is the distributor.

The Cusip number is 48125TQE8.

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