JPMorgan’s $7.55 million barrier absolute return notes on S&P may underperform even cash

By Emma Trincal

New York, Dec. 19 – JPMorgan Chase Financial Co. LLC’s $7.55 million of 0% barrier absolute return notes with daily barrier observation offer principal protection with a minimum return, two appealing features for conservative investors. But the risk of underperforming bonds or even money markets is high, advisers said.

The notes due Dec. 12, 2024 are linked to the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

A barrier event will occur if the index closes above the upper barrier, 125% of the initial level, or below the lower barrier, 75% of the initial level, during the life of the notes.

If a barrier event occurs, the payout at maturity will be par plus 6.6%.

If no barrier event occurs, investors will receive par plus the absolute value of the index return, subject to a minimum payout of par plus 6.6%.

Locked in

“This is almost a volatility play, not really a typical absolute return note,” said a financial adviser noticing that the benefit of the notes is lost if the index at any time moves outside of the range defined by the two barriers.

“If it breaches, you’re sort of locked in. Let’s say it happens only a few months before maturity, I wonder if the issuer would repurchase it from you if you wanted to sell.”

The note in that case would be guaranteed to yield only 3.3% a year, a disappointing performance for clients, he said.

This adviser said he has sold a few notes on the secondary market before.

“We got 96 or 98 cents on the dollar. But we were up significantly. One of those notes was up 50%. So, taking a 2% or 4% haircut on a 50% gain, that’s no big deal. It would be interesting to know what kind of bid you would get from the issuer if the barrier happened to breach with this note,” he said.

Upper barrier

This adviser often measures risk using back-testing data based on rolling periods. This method, he said, was useless in this case given that the barrier event can occur on any trading day rather than point to point. This type of daily observation enhances the risk compared to a simple observation at maturity, he explained.

“On a two-year, I’m not terribly worried about breaching on the downside. For that timeframe, the probability of being down more than 25% is only 4%,” he said. “Unfortunately, I don’t have a good way to statistically determine the probability of breaching on any given trading day. I only have the data on a point-to-point basis.”

The S&P was more likely to cross the upper barrier than the lower barrier, he said, even if he did not have the statistical tools to test such assumption.

“I imagine that the potential for being up more than 25% is greater than the chances of a drop of more than 25% just based on where we are in the market. The S&P will probably recover within the next two years so the chance of breaching on the upside is a bigger risk. You’re rooting for the market not to go up.”

No downside risk

Since investors cannot lose their principal due to the market, the worst that can happen is to only receive the 6.6% minimum return, he said.

“That’s a very unique kind of risk.

“With most notes, if you breach a barrier, you’ve got a major negative return. You break a 70% barrier, and you lose at least 30%. You can also take a big hit with a small buffer.

“Here, the worse you can do is get your money back plus 6.6%.

“It may also be the most probable scenario,” he said.

Bond substitute

This adviser compared the notes to a bond.

“There is no risk of loss barring JPMorgan going under. So, it’s like a bond,” he said. He assumed the notes would only return 6.6% because the probabilities for a barrier event to occur were just so high.

A two-year treasury yields 4.25%, or 8.5% in two years, he noted.

The two-year Treasury note would therefore outperform the minimum return of the notes by almost 2%, he said.

“You’ll underperform for the potential of making 25%. If you’re willing to take that bet, I can see why it would make sense. But it’s a bet and not really a bet on the direction of the market. It’s a bet on volatility,” he said.

The complexity of the structure was perhaps the most serious deterrent to buying the notes, this adviser said.

“Even a sophisticated client would have a problem understanding the terms. It’s a super complicated product with a lot of moving parts. It would be very difficult to explain it,” he said.

“The more difficult it is to explain a note, the higher the chances for the client to be disappointed. There are just too many parts and too much risk of unmet expectations to justify the hassle.”

Underperformer

Jerry Verseput, president of Veripax Wealth Management, said he did not like the high probabilities of underperforming even the safest assets.

“You’ll get 6.6% either way but you may not get more at the end of the two-year period,” he said.

“You’re betting on that -25%+25% range. It seems more like a gamble than an investment.”

“It’s principal-protected, but in all likelihood, all you’re going to get is 3.3% a year because there is a high probability that one of those barriers will be breached during that time, especially if it can happen any time.

“3.3% a year ... all money markets are paying that if not more. At least with a money market, your returns are compounded, which is not the case here since you get paid at maturity.

“I’m struggling to understand what problem this note is trying to solve. Any kind of bond would give you a better return than that.

“If you want growth, there are better ways to solve that. If you want income, there are better ways to solve that. I can’t figure out why anyone would do this.”

J.P. Morgan Securities LLC and UBS Financial Services Inc. are the agents.

The notes are guaranteed by JPMorgan Chase & Co.

The notes settled on Dec. 14.

The Cusip number is 48133PZQ9.

The fee is 1.5%.

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