Several concerns rested heavily on institutional investors in 2014, chief among them how to develop products compliant with ill-defined regulatory constraints. JP Morgan rose to the challenge with gusto.
One large institutional asset manager requested a mandatory, exchangeable note solution it could incorporate within both an onshore and offshore fund in a manner compliant with the US Hiring Incentives to Restore Employment (Hire) Act. This code imposes the US withholding tax of 30% on dividend-equivalent payments received by non-US persons, including those contained in equity-linked investments.
"The challenge was creating a legal structure that married well with the client's objectives. We designed a structure where both funds were served by a single Rule 144A private placement, which we settle in cash rather than stock. Our ability to deliver a consistent platform across different fund types while complying with regulation was a differentiating point for this client," says Larry Wilson, managing director for equity derivatives sales, North America at JP Morgan in New York.
Each domicile would typically require a separate transaction, but the asset manager client wanted to consolidate the trade under a single security identifier to be efficient from an operational, market and tax perspective. The latter is of increasing concern to asset managers due to the enactment of Section 871(m) of the US Internal Revenue Code, introduced under the Hire Act, and the broad scope of proposed rules to implement it. The final regulations are expected to adopt the approach of these proposals.
The structure JP Morgan came up with is fully compliant with both the statutory provision and requirements of the proposed regulations. While it was a tailored solution, Wilson believes it is replicable enough to be rolled out to other institutional clients with funds in both onshore and offshore accounts.
“We were able to access deep pockets of liquidity and offset risk by leaning on our strong institutional footprint with investors who wanted to express different cross-asset views” – Larry Wilson, head of structured investments distributor marketing in New York
The list of heavyweight US investors fed up with expensive and often underperforming allocations to alternative active managers continued to grow in 2014. Less remarked upon was the increasing number seeking to test-drive passive alternative investments in the form of algo-driven systematic strategy indexes - a market where JP Morgan has been head and shoulders above its peers over the past year.
One illustration is a deal with a large mutual insurer that was seeking exposure to a range of asset classes, including equity, rates, commodities and volatility, in an all-in-one index that maximised returns while restraining volatility.
Of the five dealers shortlisted by the insurer, JP Morgan ran away with the mandate, the client tells Structured Products, by offering a broad range of strategies across 50 indexes - from which the insurer could choose - and presenting a transparent algorithm to determine allocations between them.
The logic underpinning this idea fitted best with the client's overall goal of optimising risk premia gains through a dynamically weighted strategy and no other dealer was able to provide the risk-return profile it was looking for. The insurer entered into a $100 million notional total return swap (TRS) on the suite of indexes with the bank in February 2014.
"The client signed off on the final portfolio and entered a TRS with us on the selected underlyings. It's done well and they've kept the position past the original maturity. We have two further mandates in the works using a similar structure," says Wilson.
JP Morgan took an innovative approach to assisting institutional clients with more bread-and-butter trades, such as helping a large insurer to overcome the challenge of hedging its variable annuity risk. These annuities are tax-deferred retirement investments with a minimum guaranteed payout and income riders linked to the performance of selected mutual funds.
The selling of these guarantees makes the insurer short long-dated equity puts, exposing it to both equity and rates risk. As interest rates fall, the value of the guarantees they are short will increase, inflicting losses.
Insurers typically use a combination of futures, options and swaps to hedge against this risk. But in order to protect against the worst-case scenario of falling rates and equities, JP Morgan worked with a large insurer to put in place a bespoke, equity interest rate hybrid options hedge. These structures provide protection against rates and equity movements at a significant discount to vanilla equity puts, thanks to the inclusion of correlation risk.
"We were able to access deep pockets of liquidity and offset risk by leaning on our strong institutional footprint with investors who wanted to express different cross-asset views. These included hedge funds, asset managers or even other insurance companies," says Wilson.
The transaction left JP Morgan's book with two types of exotic risk: equity and rates correlation, and digital risk. The digital risk refers to the danger that towards expiration, the equity put is in-the-money, but the rate component is close to the barrier beyond which it will knock out. On the flipside, it can refer to when the rates component is in-the-money, but the put is close to expiring at or below the strike price.
Trying to lay off both risks to the Street in combination is difficult, as digital risk increases in tandem with correlation risk, so JP Morgan's sales, trading and structuring teams worked together to disaggregate the digital risk to make it easier to hedge.