Credit Suisse’s capped gears tied to Russell 2000 offer short-term alternative to ETF exposure

By Emma Trincal

New York, Feb. 8 – Credit Suisse AG, London Branch’s 0% capped gears due April 30, 2020 linked to the Russell 2000 index provide investors an alternative to an exchange-trade fund, said Suzi Hampson, head of research at Future Value Consultants.

“This note can be used as an alternative to the various versions of ETFs that track this mainstream index. But the note offers something different, which is more useful for moderately bullish investors, people who don’t expect the index to move up a lot,” she said.

The payout at maturity will be par plus triple any index gain, up to a maximum gain expected to be between 14.75% to 16.75%., according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be exposed to any losses.

Up not down

The main difference with an ETF is the “asymmetrical payoff,” she explained.

“This note is very similar to an ETF except for the leverage.

“If you invested in an ETF your risk profile would be similar: you would have a one-for-one downside exposure. On the upside however the note gives you a very high gearing and it caps out.

ETF investors may benefit from greater liquidity. But any leverage would apply symmetrically, adding risk for investors.

“Having leverage only on the upside is quite an advantage to structured products. It’s not easy to get this kind of payoff elsewhere. You could do it with options, but it would be a bit complicated to put together and also quite expensive,” she said.

No protection

The very short-term note with the accelerated return, capped upside and no protection on the downside is also a category unto itself within leveraged products, she added.

“This is not designed for investors who are used to buying structured products with some kind of downside protection,” she said.

Typically, leveraged notes will come with a cap limiting the gains in exchange for the protection on the downside.

This product however has eliminated the protection in order to increase the leverage, she explained.

“No barrier or buffer...but you do get a huge gearing and that’s the tradeoff. It makes this type of product unique. It’s an effective way to compete with an ETF,” she said.

Low ambitions

The leverage amount is rarely proportional with the level of bullishness of an investor, she said.

“You need 5.25% per annum to reach the cap. That is not a high return by any means. The note is quite highly geared and it’s going to have an impact on your maximum return. If you had a lower gearing, you would be given a higher cap,” she said.

Investors in the notes must expect only a modest growth in the Russell 2000 index.

“If you are aggressively bullish, you’d rather not have a cap. You want no cap or a much higher cap, which would require less leverage and in some cases no leverage at all,” she said.

No market call

To illustrate some of the characteristics of the note, Hampson ran a report on the note using her firm’s proprietary stress testing model. She picked a hypothetical cap of 15.75% at the midpoint of the range.

Each report contains a total of 29 sections or tests, which encompass simulation tables and back-testing analysis.

A neutral scenario is the basis of the simulation in all reports. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

Four other market assumptions are used in the Monte Carlo simulation: bullish, bearish, less volatile and more volatile.

Each scenario is conservative in nature, according to the research firm’s methodology. For instance, under the bull scenario, the model assumed an annualized rate of return of 7% for the Russell 2000 index.

The neutral scenario is always very deceiving as it is not designed to be a hypothetical market scenario but rather a basis for comparison between the different markets, she explained. If one had to take into account the neutral scenario, the rate of return for the underlying index would be 1% a year.

“We don’t use the neutral to help our clients make predictions,” she said.

“Even what we call a bull scenario is based on a very subdued growth rate.

“7% a year for equity is not very ambitious. But it’s not unreasonable either.

“We are aware that our choice reflects some level of subjectivity. But the main goal is to refrain from the temptation of predicting the market.”

For equity investors with equity market return expectations, it is “crucial” to switch to the bull scenario, she said.

“While modest, the growth rate of the bull scenario has a great impact if you compare it with the neutral assumption.

The probabilities of getting a positive return increase considerably under the bullish scenario.

Capping easily

One of the tables in the report, called “capital performance tests “displays the probability of each of three outcomes: return more than capital, return exactly capital and return less than capital.

The table showed that under the neutral scenario, investors had a 58% chance of getting a positive return versus 42% chances of “returning” less than capital. The bucket “return exactly capital” is void since there is no barrier or buffer in the notes.

The outcome for the notes is either a gain or a loss,” she explained.

A look at another table called products specific tests shed some light on the relationship between gains and cap. Under the neutral scenario, out of the 58% chance of receiving a positive return, the scenario in which such return is equal to the cap carries a probability of 46%.

Subtracting the two probabilities showed that it’s only 12% of the time that a positive return will be distinct from the cap, hence lower.

A look at the same buckets but in the bullish scenario reached a similar conclusion.

Getting a positive return will occur 70% of the time. Within this bucket, investors will hit the cap 60% of the time, therefore will earn less 10% of the time.

“The higher the leverage, the easier to cap out. It’s almost as if when you get a positive return it’s going to be the cap. Very similar to a digital product. It’s only in about 10% or 12% of the time that you will receive a positive return that’s not the cap,” she said.

“We can oversimplify it and say that if you get a positive return, it will be the cap.”

Losing easily

The lack of any protection, even under the bullish scenario, has a visible impact: the odds of getting less than capital are 27%.

But Hampson said it’s much harder to get a sense of how heavy the losses may be.

On average, losses will amount to 15% of principal, according to a payoff table for the bull scenario.

On the downside, the probability of losing capital is 27% in the bull scenario. The average loss in this case is 15%.

“This figure is not very telling because it’s only an average. We don’t really know how much you lose. It could be 2% it could be more.”

When there is a barrier observed at maturity, assessing the amount of losses is easier, she said.

For instance, a 60% barrier when breached will automatically signal a loss of at least 40%.

“With this growth product, you don’t really know how much you can lose. But you know that the probabilities of losing money are quite high. It will happen more than a quarter of the time,” she said.

“Investors who may benefit from this the most need to be reasonably risk-aware. At the same time, they don’t have to be very bullish to outperform the market or the equivalent ETF,” she said.

Low expectations on market returns and readiness to take losses will make the notes a suitable alternative to an ETF, she concluded.

UBS Financial Services Inc. is the distributor.

The notes will price on Feb. 25.

The Cusip number is 22549Y644.

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