Credit Suisse leveraged notes tied to iShares Barclays 20+ Treasury offer bearish bet on bonds

By Emma Trincal

New York, Dec. 16 - Credit Suisse's planned leveraged bear notes linked to the iShares Barclays 20+ Year Treasury bond fund offer investors a potential hedge against interest rates risk at a time of uncertainty regarding the future direction of government bond prices, sources said.

Credit Suisse, New York Branch plans to price two times leveraged bear notes due January 2011 linked to the iShares Barclays 20+ Year Treasury Bond fund, according to a term sheet.

The notes are expected to price at up to 102.5% of par, with the premium value accounting for the 2.5% fee paid upfront.

The notes will be called if the fund's shares trade at or above 130% of the initial share price.

The payout upon redemption or at maturity will be par plus double the reverse fund return plus the notional interest amount minus the accrued borrow cost minus the dividend amount. The double leverage applies to both the upside and the downside with the 30% limit operating as a protective barrier on the downside.

The iShares Barclays 20+ Year Treasury Bond Fund is an exchange-traded fund that seeks to replicate the price and yield performance of the long-term sector of the U.S. Treasury market as defined by the Barclays Capital U.S. 20+ Year Treasury bond index. This index is a market capitalization-weighted index that includes Treasury securities with a remaining maturity greater than 20 years.

Bearish bet on Treasuries

The Credit Suisse notes represent a bearish bet on long-term Treasuries, said a source, with investors hoping that long-term interest rates will go up.

"Betting on a Treasury selloff makes sense right now," said Brian Battle, vice-president at The Performance Trust Cos. LLC, a broker-dealer specializing in fixed income.

He said that long-term rates in relation to the Fed could go up in two opposite scenarios - whether the Fed acts too much or too little, which gives bears a lot of room to be right.

"If the Fed waits, and waits before raising rates, maybe the long end [rates] will go higher because people will worry about inflation," he said. Another possibility, while less likely, he added, would be that "All of a sudden the Fed raises rates by 2% and of course, people would panic about inflation," he said.

"The bond market always raises rates before the Fed does. It's a given," Battle said.

Hedging

During its Federal Open Market Committee meeting on Wednesday, the Fed reasserted its vow to keep interest rates "exceptionally low" for "an extended period" and said that the economy was strengthening.

"Some people who have a long exposure to the bond market may find in these notes an effective way to hedge the interest rate risk, the Fed risk," said Norman Papoose, president of Evaluate my Advisor and a former index-linked notes structurer in London.

Options

With the Fed unwinding its agency mortgage-backed securities early next year and the economy picking up in strength, inflation fears have increased.

Sources said that betting on a Treasury selloff is a timely and worthy theme but that other alternatives exist to express this view.

Papoose said that, "I don't really see why I would pay for the structure when it's easy to go to the option market."

"It makes a lot of sense to bet on higher interest rates, but why not invest in a fund directly?" said Battle.

Battle suggested the ProShares UltraShort 20+ Year Treasury Bond ETF as an alternative as it also represents a bearish bet on treasuries with a maturity greater than 20 years in a format that also employs a double level of leverage. "You pursue the same market theme but with liquidity and without the credit risk," he said.

Battle also said that he would prefer to use options, not just for cost-efficiency but also as a way to reduce risk.

"If you think Treasury rates are going to go up, you should buy puts," he said.

"If you buy Treasury puts, your expense would be much less and you could get way more leverage than two at a fraction of the cost," he added.

Battle said that he liked the call feature in the structure, which limits losses to 30% on the downside. "I think this is good," he said.

However, he said he preferred the use of options because the downside risk would be easier to assess.

"When you buy a put and lose, your option expires worthless. All you lost was the cost of your premium and it's limited. You know what the risk is in advance," he said.

The notes are expected to price Dec. 18.

Credit Suisse Securities (USA) LLC is the agent. Morgan Stanley Smith Barney is the distributor.

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