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The water is calm. The sky is a crystal blue with a puffy white cloud in the distance. The sun is warming your face and the wind is so light it is barely ruffling your hair.
It’s a gorgeous day and you are bobbing around in a boat but the sails are luffing and you are wondering how you will get back to shore. Out of nowhere a steady 12-knot wind rises and you cruise in to port. Just as quickly the wind vanishes.
It was into this timely gust that JP Morgan Private Bank launched its new Max note four weeks ago. A three-year bond, it pays interest at a rate that resets quarterly to the yield on the two-, five- or 10-year Treasury bond, depending on which one is highest.
“This is a trade I have been trying to do for four years,” says Anton Pil, managing director and global head of fixed income, currency and commodities for JP Morgan’s private clients. “I’ve been trying to do a trade where clients don’t have to worry where they are on the yield curve.”
A flat US Treasury yield curve made the time right. If the curve were steep – in other words paying a significantly higher yield on longer maturity bonds than on short-term paper – the trade would not work; paying the holder of a three-year bond the higher yield of a 10-year note would be great for the investor but unsustainable for the bank.
But the difference between the two-, five- and 10-year notes is negligible by historical standards (even though it has widened somewhat in the last few weeks). In other words, an investor is not paid substantially more for holding a theoretically riskier 10-year bond than a safer two-year one. Pil could only think of two other moments when this trade could have been done – in 1989 and for a few months in 1999.
Since its coupon resets every quarter, the Max note will automatically pay out the highest amount and keep the risk low. Currently, it is paying the 10-year rate of 5.04 per cent from when the note was launched. (Its competition is traditional floating-rate notes, which are reset off Libor, the London inter-bank offered rate.)
Max’s advantage is that it removes any need to take a view on what the yield curve will look like in three years. If, for example, the five-year is offering the highest yield six quarters from now, investors will get that coupon; if in the seventh quarter it is the two-year, they will get that one.
Pil says the bank’s view is the 10-year will pay more in three years and the two-year will drop, so an investor will benefit by getting a 10-year rate on three-year paper. But anything that makes two-, five- and 10-year bonds look different from each other is good because the investor gets paid the highest rate.
People have been ableto do this before – using derivatives – but they had to take a definite view on the yield curve. For example, they could go long on the 10-year and short on the two-year. But this required leverage; it also required a definite idea about which way the bonds were going.
Pil says: “[The Max note] is for people who don’t want to take a view beyond [the idea that] the yield curve will not stay flat . . . [or for] those who don’t have a lot of confidence in a curve trade.”
Even though it was the flattened curve that created the possibility for this trade, it also coincided with the bank recommending high cash positions of 7 to 10 per cent for its clients, Pil says. “This is a good substitute with cash-like features,” he says. “It was created to absorb large cash positions.”
The downsides of the Max are significant but are unlikely prospects. If the yield curve were to invert for more than a year the note would underperform. It would be possible to do better by buying even shorter-dated bonds. Similarly, if Libor was above two-year rates for a three-year period the note would not be so appealing.
Right now, the concern is waiting for the next window to issue the notes. JP Morgan has already sold $250m worth of Max notes and a little more in derivative form. The bank would like to sell another $200m but it is constrained because the yield curve is steepening.
With something like this, timing is crucial. The original issue came to market in a matter of days before conditions changed. “It was windy. You had to be out there,” says Pil, picking up the sailing analogy. If you missed it, “a motor boat would look good”.
Those best suited for the Max note include non-taxpayers such as foundations, endowments, and non-US citizens and taxpayers who believe the yield curve will steepen and make this a better trade than municipal bonds. It also works for people who pay the alternative minimum tax because they would discount the coupon by their 28 per cent tax rate, not the top 35 per cent rate. Clients have on average each bought $300,000 to $500,000 worth of Max notes.
But even a straightforward product can be spiced up for risk-takers. In addition to derivatives – which give you the Max exposure without owning the actual note – the bank has also built Max notes with embedded Brazil risk, instead of JP Morgan issuer risk. This gives investors another 50 basis points of return but also brings the risk of a Brazilian default – when they get nothing.
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