JPMorgan's leveraged notes linked to the S&P 500 are designed for mild, risk-taking bulls

By Emma Trincal

New York, Aug. 13 - JPMorgan Chase & Co.'s 0% capped return enhanced notes due Sept. 4, 2014 linked to the S&P 500 index offer a simple structure for mildly bullish investors, sources said. The final-days averaging, which is the less common feature of the structure, does very little to add protection, they noted. Investors as a result should be willing to take a loss if the index declines.

The payout at maturity will be par plus double any gain in the index, subject to a maximum return of at least 15.7% that will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will be fully exposed to any decline in the index.

The final index level will be the average of the index's closing levels on five averaging dates ending Aug. 29, 2014.

Not too bullish

"It would make sense for somebody moderately bullish. If you're completely bullish, you would go and buy the S&P," said Tom Balcom, founder of 1650 Wealth Management.

"I'm not sure why they did the averaging at the end whether it was based on investors' demand to protect them against a one-day sell-off or if it was related to the price of the option. But this aspect of the deal is unlikely to make a difference in terms of index performance at the end. Who knows what will happen in the last five days of the deal? It could be designed to protect the client from a dramatic one-date drop, but it's just a guess."

Investors in the notes cannot be bearish or uncertain about the market direction since there is no downside protection, he noted.

"Say you bought the S&P 500 with the 2% dividend and the market is down. You would be better off with the long-only position because you would get the 2% extra, which you don't get here," he added.

"But if you think that the market has been up quite a lot so far and that it's not going to continue to go up at the same pace for the next 12 months, then you may use the leverage to your benefit."

Replication

Michael Iver, chief executive of iVerit Consultancy and a former structurer, said that the deal was "a very simple trade" that retail investors could "almost replicate" themselves aside from finding the exact contracts matching the maturity date of the notes.

"You basically have full downside risk on a one-for-one basis and upside participation capped at 7.85% of the S&P 500 leveraged two times," Iver said.

"This note is the equivalent of a long position in the S&P and a call spread.

"You buy the S&P 500 ETF, that's your long position in the index, and at the same time, you buy an at-the-money call. Those two long positions combined give you the two times leverage.

"Separately, you sell two calls that are 7.85% out-of-the-money, and that's your cap.

"So what you have is no downside protection, twice the index return and a 15.7% cap.

"What you don't have is the 1.96% dividend yield on the S&P 500, the one-year risk-free Treasury rate of 13 basis points and the one-year CDS rate of the issuer.

"You can't exactly replicate the trade because you don't have options contracts expiring in September 2014 right now.

"But basically, that's the deal."

Iver said that the simplicity should help secondary market transactions.

"I would think that any dealer could provide pretty good liquidity on it. It's a simple structure," he said.

The less common feature of the notes, the five-closing-days averaging, should not be perceived as a form of downside protection, sources said.

"This is for people who think the market is going to appreciate next year but not by a lot, not by more than 7.85%. They also expect the market to go down; otherwise, they would demand protection," Iver said.

"The averaging of the last five days has no appreciable impact on the return. Five days over one year is really not much. Rather it's designed to provide confidence in the settlement price. It's a way to protect investors against any potential market manipulation, any big one-day trade, a big buy or a big sell order on the S&P which would be messing up the settlement price of the deal.

"The averaging we have in this deal is very different from when you are averaging frequently over a longer period of time. When you average returns each quarter over the life of a deal, it's going to modify the final return. Not here."

No safety net

By giving up any downside protection, investors have to be confident that the index performance will be positive in the final days of the notes.

Leveraged return notes with no downside protection have grown more popular this year, according to data compiled by Prospect News.

These products account for 20.33% of the total volume issued this year versus 15.55% last year; their volume is up 32% to $4.56 billion year to date, according to the data.

"When people decide to buy leveraged notes with no downside protection it means one or two things: Either people are very confident or the cost of buying downside protection is very high," Iver said.

"If issuers are able to sell a lot of those deals, then those two statements are probably true: Investors have become very confident in the market, and the pricing of downside protection has become expensive.

"In both cases, the statements are very bullish, and this deal reflects a continuation of that view. I would be very careful. The market has had a very good run. You want to buy downside protection when you think you need it the least. That would be my only advice."

The notes (Cusip: 48126NNM5) are expected to price Friday and settle Aug. 21.

J.P. Morgan Securities LLC is the agent.

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