JPMorgan's 21% reverse convertibles linked to Netflix offer eye-catching yield for bulls only

By Emma Trincal

New York, April 9 - JPMorgan Chase & Co.'s 21% reverse convertible notes due July 17, 2013 linked to the common stock of Netflix, Inc. offer an attractive headline coupon, but investors should be willing to own the stock and not just buy the notes for the income, sources said.

The payout at maturity will be par in cash unless Netflix shares fall below 75% of the initial price during the life of the notes and finish below the initial price, in which case the payout will be a number of Netflix shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

"It's a highly volatile stock. I hope it's not sold as an income play because it's a tough story to tell your client if you're down 40% on the stock," said Tom Balcom, founder of 1650 Wealth Management.

The current implied volatility of the stock is 79.6. The stock closed at roughly $169 on Tuesday. So far this year, the share price is up nearly 85%. The stock peaked in July 2011 at $291 and hit a low in September at $54. Since then, the price of the stock has surged by more than three-fold.

Equity play for bulls

"It's only for bullish speculators on Netflix," Balcom said.

"If you are bearish on the stock and worried about the volatility, I definitely would not touch this.

"This type of income is very appealing, but you're getting paid for the risk. Return and risk are positively correlated.

"If they miss their earnings for whatever reason, then the person who bought this would not be so happy. If they don't miss their earnings, then the investor should be fine."

Netflix is expected to report earnings on April 22 for the fiscal quarter ended in March.

Balcom said that with the 10-year Treasury yield lower than the dividend yield of the S&P 500, investors may find reverse convertibles such as this one very tempting.

"Reverse convertibles involve considerable risk. Very few RIAs use them because of that," he said.

"The yield for this note is very enticing, but the possible downside associated with this investment is probably not worth the potential unhappy client.

"It's not necessarily a bad product, but I would never categorize it as an income product. You get this equity exposure.

"People are searching for yield. But the risk is commensurate with the gain.

"If you sell this note to a client, if you think the stock won't go down by more than 25% in the next three months and won't finish down, I really hope that you're right. I'd hate to be on the receiving end from a client who would tell me, 'I've received a coupon, but now the stock is down. I've lost a lot of money.'"

For some investors, however, the notes may be appropriate.

"If you're bullish on Netflix, this can be a solid investment, one that offers the yield and some contingent protection.

"But I wouldn't advise anyone to buy it for the income. You have to be bullish. You can't be bearish or risk averse," he said.

Monetizing volatility

Michael Iver, founder of iVerit Consultancy and a former structurer, said that buying the notes is the equivalent of selling a put on the stock. The strategy is designed for investors willing to own the shares and seeking additional income. The willingness to take the downside risk should exclude any bearish investors, he noted.

"This is for someone who wants to sell the recent volatility in the stock, earning a high coupon for three months' risk, and who is not bearish on Netflix," Iver said.

"You're selling a put option on a very volatile stock; that's how you're earning the high coupon."

He noted that the coupon, which is payable regardless of the stock return, can also be used defensively.

"The high coupon serves as a partial buffer to the final price. It's not a perfect buffer. It's a 5.75% coupon. But at least it will buy you some cushion," he said.

"It also provides you the protection of up to 25%. It's not really a very bullish trade. But it's definitely not a bearish play."

Entry strategy

Despite the downside protection - the barrier in addition to the coupon - investors are still exposed to the full downside, he noted.

"As an investor in this product, you think there is no way this trigger will happen, and if it does happen, you don't really care that much because you believe in Netflix in the long run. Selling the volatility is a way to reduce the cost of your entry. You like the stock; you want to buy it. This reverse convertible enables you to buy the stock at a lower price," Iver said, referring to the "discount" provided by the coupon.

A very bullish investor, despite the already relatively high coupon on the notes, may want to earn even more, he noted.

"If you think the stock could go up more, you probably shouldn't buy this as a single investment. Instead, you should probably combine buying the stock itself and buying the deal," he said.

"If the stock is up, you collect your coupon and get your money back in three months. You also get the pure upside exposure of owning the stock. Plus it's a way to own the stock for less.

"The bottom line is you can't buy this product unless you really have an opinion on the stock.

"You're bullish. You think the stock will go up. You're willing to own it if you're wrong. And you're happy to collect the coupon."

The notes are expected to price Friday and settle April 17.

Interest on the notes will be payable on May 17, June 17 and July 17.

J.P. Morgan Securities LLC is the agent.

The Cusip number is 48126DM89.

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