AMJ Suspends Creations: Should Investors Bet On A Premium?

Jun.18.12 | About: JPMorgan Alerian (AMJ)

JPMorgan recently announced that its Alerian MLP ETN (NYSEARCA:AMJ) is near its share limit, and will soon cease to create new shares, effectively hobbling the mechanism which keeps an ETN trading at its underlying value. We've seen this happen several times before, recently with GAZ, TVIX, and in an extreme case further back, GOE. All traded at a significant premium to underlying value, and the possibility of AMJ trading at a premium is also significant.

ETFs and ETNs have a creation and redemption mechanism in place to keep the products trading price in line with its underlying value. It works because the process allows arbitrageurs to take advantage of premiums or discounts.

With the share count of AMJ capped, arbitrageurs can no longer sell short shares at a premium and buy back shares at underlying value from JPMorgan, thus eliminating the possibility of arbitrage.

What's interesting is that the share redemption process is not affected. From the prospectus:

This size limitation does not affect the weekly repurchase rights at the option of noteholders described in this reopening pricing
supplement and the accompanying product supplement.

This means that shares will no longer be created to satisfy demand if the price rises above underlying value, but if demand drops and AMJ starts trading at a discount, then shares can still be redeemed and the discount can be arbitraged away.

This has the potential to be an interesting trade, because investors can bet on the possibility of premium without the risk of a discount, as a significant discount would be quickly arbitraged away.

So what's the catch, and why isn't AMJ already trading at a premium to reflect this? First of all, AMJ is a big product. At over $4 billion in shares outstanding, any premium doesn't have much chance of being as large, as it would take more money to push up the price. Other products in the past have been much smaller, making it much easier for them to trade at a premium. There is also one last batch of shares being issued by JPMorgan, on or around the 19th, so there is still some supply to satisfy demand for the time being.

Unless JPMorgan starts issuing shares again, I think buying AMJ offers the opportunity to pick up a couple percent in outperformance. For investors who own it already or own a similar product, there doesn't seem to be much risk in trying to capture a possible premium, as share redemptions have not been halted.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AMJ over the next 72 hours.