Credit Suisse’s $25 million X-Links crude oil covered call ETNs: a novel way to boost yield

By Emma Trincal

New York, April 27 – Credit Suisse AG’s launch of its X-Links Crude Oil Shares Covered Call exchange-traded notes on Wednesday is one of the latest examples of issuers introducing innovative strategies to satisfy investors’ continued appetite for yield, sources said.

Most income-generating structured products are typically autocallable contingent coupon notes with single-underlying or worst of features. Manufacturers of exchange-traded notes are following suit with simpler structures tied to sophisticated strategies, tapping into a wider range of asset classes.

Credit Suisse AG, Nassau Branch priced $25 million of Credit Suisse X-Links Crude Oil Shares Covered Call exchange-traded notes due April 24, 2037 linked to the performance of the price return version of the Credit Suisse Nasdaq WTI Crude Oil Flows 106 index, according to a 424B2 filing with the Securities and Exchange Commission.

X-Links series

The index measures the return of a covered call strategy on the shares of the United States Oil Fund, LP exchange-traded fund which reflects changes in the price of U.S. Oil shares and the notional option premiums received from the notional sale of monthly call options on U.S. Oil shares less the notional transaction costs incurred in connection with the implementation of the covered call strategy, according to the prospectus.

The variable coupon is based on the notional option premiums, which is paid monthly. The payment is uncertain and Credit Suisse warns it could be zero.

Credit Suisse has priced similar covered call ETNs in its X-Links series before. Those were based on other commodities, such as gold and silver. The exposure to crude oil is used for the first time.

Strategy

“This is not about taking a view on oil. It’s just a buy-write strategy that lets you earn income for a limited upside,” a market participant said.

Issuers have been looking for a variety of techniques designed to generate higher yield, he said. Commodities don’t usually come to mind when one thinks of yield.

“There is no way to earn income from oil. That’s probably why they did it,” he said.

An industry source welcomed the use of covered calls on a non-equity underlying.

“It’s pretty interesting. The buy-write on the S&P is a well-known strategy. If it works well, you take that same idea and apply it to a more volatile, esoteric asset class to get more income.

“It goes to show that people really want more income because going from the S&P to oil is more risky.”

Out of the money

The number 106 in the title of the underlying index is the strike price of the strategy based on a hypothetical initial price of 100, also known as the at-the-money price in option terminology.

Being short a call option at a strike of 106 means the writer (seller) will have to sell the stock at the price of 106 if it increases above this strike level. Such an outcome, called assignment, represents a risk for which the option seller is paid a premium.

The Credit Suisse X-Linked Crude Oil Shares Covered Call ETN has a higher, out-of-the-money strike price of 106, which gives investors more upside participation measured as the difference between the strike price and the initial price. However the premium paid is lower since the call writer has a greater probability of being right in betting that the price will not exceed the strike. An at-the-money call (strike of 100) or in-the-money call (strike below 100) would have significantly increased the amount of premium.

Roll

The ETN however provides a different setting for the buy-write strategy.

Each month, the option contract is rolled and a new strike price is determined and set at 106% of the price on the determination date, based on some rules, according to the prospectus.

“The index doesn’t let the option expire. The stock is never called away. This is really a product designed to generate income on a consistent basis,” the market participant said.

Cost

One factor limiting the variable coupon is cost, according to the prospectus.

The monthly appreciation of the index, already capped at the strike price can be further reduced by the notional transaction costs.

The roll of the contract (selling to open the call option position and buying to close it) along with the cost of selling the U.S. Oil shares represent in total an 0.84% annual cost.

In addition, the ETN charges an annual investor fee of 0.85%.

Risk-reward

While considered somewhat conservative because investors are long the underlying stock, a covered call strategy offers limited return while still presenting some risks.

The maximum return is the amount of coupon received plus the appreciation of the index. The coupon is restricted to the amount of premium. The upside cannot exceed the strike price of each contract during its term.

Inversely, the maximum loss would be the initial investment minus the amount of coupon received.

The coupon is not guaranteed, making this investment distinct from a bond and probably unsuitable for most fixed-income, conservative investors, sources said.

Volatility

The volatility associated with crude oil futures offers more risk but also better opportunities, the industry source said.

“Oil is volatile so it can go up a lot... if you can get 6% a month, it’s interesting to do that obviously,” he said.

The 6% gain represents the maximum return capped at the 106 strike, which is reset monthly.

“But if the index starts to drop a lot, you could end up losing on the down months and your income will not be enough to offset those losses.”

An increase in implied volatility will typically provide more premium on the short side and will increase the cost of buying the option. At the end of each month the index synthetically sells a contract and buys the old one to close the position.

Because the index rolls the contracts, the strategy may actually benefit investors, said Larry McMillan, president of McMillan Analysis Corp.

“You’re buying it back at parity. The implied has no effect on the expiration on the last day,” he said.

“But on the sell, for the next month, the higher implied gives you a better entry.”

Selling volatility is an income-generating recipe used in a variety of structures, the industry source said.

The use of a more volatile asset class is precisely designed to boost the yield.

“Right now there’s no high demand for commodities. There’s no overwhelming consensus that you should own this asset class. But volatility on the S&P has collapsed and so people are looking at different corners. This is not a bet on commodities. It’s an income play.

“It’s riskier, no doubt. But it offers more opportunities.”

Credit Suisse sold $5 million of the ETNs at par of $25.00 on Wednesday. The remaining ETNs will be sold at variable prices.

Similar “X-Links” Covered Call ETNs have been priced in the past. One series was linked to the Credit Suisse Nasdaq Silver Flows 106 index; the other to the Credit Suisse Nasdaq Gold Flows 103 index.

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