JPMorgan's daily liquidity notes on Dow Jones-UBS Corn offer early redemption, seen as costly

By Emma Trincal

New York, July 19 - JPMorgan Chase & Co. announced the pricing of 0% daily liquidity notes due July 19, 2013 linked to the Dow Jones-UBS Corn 3 Month Forward Total Return sub-index, the first offering in a new series of notes that gives investors the option to redeem their notes early on a daily basis under certain rules and at an established cost.

The notes will not be listed on any securities exchange, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity is linked to the performance of the index minus a 0.8% investor fee.

In addition, investors are charged a purchase fee of 0.5% when they buy the notes.

In future offerings, the underlying commodity index may be the S&P GSCI index, a commodity sector sub-index of the S&P GSCI, the Dow Jones-UBS Commodity index or a single-commodity sub-index of the Dow Jones-UBS Commodity.

Pioneer deal

Sources said that the most noteworthy aspect of the product was the early repurchase right granted to investors by the issuer.

"I've not seen anything like that before," said Brad Livingston, a distributor at Laidlaw & Co.'s Income Solutions Group.

Typically, investors in structured products get daily liquidity only via exchange-traded notes, which are listed on a securities exchange.

Selling a traditional structured product prior to maturity on the secondary market is an option, but issuers carefully draft their prospectuses in ways that caution investors about the risks involved with secondary market trading. Most filings state that secondary market sales will depend on the price, if any, the issuer is willing to buy back the notes. Some prospectuses may also tell investors that other dealers are unlikely to make a secondary market for the notes, stressing that liquidity is very limited for structured products on the secondary market.

The terms of the deal are distinct from rules that generally apply to secondary market sales. JPMorgan stated that when it wrote that "we will not purchase the notes in the secondary market."

Instead, investors have the option to send by email a repurchase notice to the issuer on the business day prior to the valuation date. Three days after the valuation date, investors will get a cash amount equal to the note value on the valuation date minus a repurchase fee of 0.6%. The valuation date is any business day, according to the filing.

"Daily liquidity is very attractive, because not having the option to redeem early has always been one of the biggest objections to structured products," said Livingston.

However, sources were cautious about the new product and examined the daily liquidity provisions in light of its cost and as part of the structure as a whole.

"Until we see how this works and whether this is something financial advisers and investors would use or if it's just a fancy marketing tool remains to be seen," said Livingston.

Selling timing

The liquidity provision may paradoxically put some investors at risk of trying to time the market because most of the underlying indexes are not designed for liquidity, Livingston said.

"Commodities are very volatile. You need time to let it play out. The S&P is not designed for short-term investors. Investors who buy structured products need to allocate money for the long run," Livingston said.

"So in a way, illiquidity of structured notes was not a valid objection in the first place. Most investors, given an opportunity to sell, will sell at the wrong time."

Others understood the appealing aspect of the liquidity provision yet were skeptical because of the cost it represented.

Bothersome fee

"I can understand that issuers would want to offer liquidity. Today, clients are not willing to lock in their money for five or six years. Everybody else is running into the same issue," said Carl Kunhardt, director of investment management and research at Quest Capital Management.

"But that 60 basis points repurchase fee bothers me. I would have to do some math and see if it makes sense. With that 60 basis points haircut, you may not be getting back even,"

Such risk is stated in the filing's selected risk considerations in the following terms: "Even if the level of the index increases, you may receive less than the principal amount of your notes due to the investor fee and/or the repurchase fee amount."

Kunhardt considered the 0.6% repurchase fee to be too high in relation to the structure of the product, which does not offer any principal-protection mechanism.

No buffering

"I don't think I would even recommend it. If there's no principal protection, if there's no buffering, why would I buy what's just a big IOU? If I'm taking all the risk up and down plus some additional cost, why not buy an ETN and be done with it?" said Kunhardt.

"The structured products I sold may charge a fee, but they give my clients some principal protection. I can rationalize the additional cost for that protection whether I buy a principal-protected instrument, generally a CD, or a note with some sort of buffering."

Kunhardt said that he would prefer buying an exchange-traded fund rather than the daily liquidity notes.

"With the notes, I am taking all the market risk. And it doesn't offer any benefit I could just get with an outright purchase of a similar vehicle. An ETF would give me daily liquidity. All I need to worry about is the trading desk commission," he said.

Callable

Another concern sources had with the deal was the fact that the issuer has the discretion to call the notes at any time.

"If the notes are redeemed by us, you will be exposed to reinvestment risk," the filing cautioned.

Kunhardt said that the call feature posed an additional problem.

"Not only do I have full downside risk, but now my upside is limited because at some point, they will call it. JPMorgan looks at the commodity index. If it takes off, it's a huge liability for them. They will call that in a heartbeat," he said.

Myth of illiquidity

A New York sellsider said that it was unclear whether the 0.8% repurchase fee offered a significant advantage over bids offered in general by issuers on the secondary market for typical structured notes.

"Most issuers will buy back their notes for less than 1%, often for 50 basis points, depending on the asset class," the sellsider said.

"When they don't give you a bid, that's rare and it means that something is really wrong. It happened at the end of 2008 during the liquidity crisis, but it doesn't happen very often."

This sellsider said that the product would attract investors who are not convinced that liquidity is sufficient on the secondary market for structured products. But some of those fears, he noted, were "ill-founded."

"Many believe that only the issuer will buy back its own paper. But it's not true. Several banks are interested in buying some of the paper out there issued by the other guys. They like the idea of splitting the credit and the option components. In other words, I think it's a lot to pay for a liquidity that already exists in the market and for a simple delta one tracker," he added.

The notes were expected to price Friday. No 424B2 filing for the notes had yet been filed with the SEC at press time.

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

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