Credit Suisse’s six-year protected Mitts with cap tied to the Dow to offer defensive exposure

By Emma Trincal

New York, June 7 – Credit Suisse AG, London Branch’s 0% Market Index Target-Term Securities due June 2025 linked to the Dow Jones industrial average offer investors a low-risk alternative to an equity exposure comparable to a bond but with the potential of higher returns, said Suzi Hampson, head of research at Future Value Consultants.

The payout at maturity will be par of $10 plus any index gain, up to a maximum return of 45% to 55%, according to a 424B2 filing with the Securities and Exchange Commission.

The exact cap will be set at pricing.

If the index falls, the payout will be par.

“This product is for risk-averse investors who want the peace of mind of holding a bond-like instrument in terms of the downside. Yet the maximum potential return will be higher than a bond issued from the same issuer because the return is not guaranteed,” she said.

“Since there is no risk of losing money as a result of market moves, investors should assess their probabilities of return, from getting no positive return to getting the maximum return and everything in between.”

Four scenarios

Future Value Consultants runs stress testing reports on structured notes using a Monte Carlo simulation model, which displays probabilities of occurrence for all of the possible outcomes in a given structure type.

The basis of the forward-looking model is a neutral scenario, which reflects standard options pricing based on the risk-free rate, dividends and volatility of the underlying.

The model also runs four market scenarios, each of which is based on an assumed growth rate and volatility associated with the underlying. Those scenarios are: bullish, bearish, less volatile and more volatile.

Product specific table

Hampson focused her analysis on the product specific tests, one of the 29 tables included in the report.

The table showed two possible outcomes: minimum return, which is getting 100% of principal back or maximum return, the equivalent of reaching the cap. Getting a negative return is not an outcome given the principal protection. Those tests exclude credit risk.

To run the Monte Carlo simulation, Hampson picked a 45% cap at the midpoint of the range.

A third outcome of course is the possibility of getting a positive return comprised between the initial price and the cap. Calculating the probability of this third outcome simply requires adding up the maximum return and minimum return buckets and then subtracting this sum from 100.

Growth-sensitive

“Because we’re dealing with a growth product as opposed to an autocall or a digital or anything with a more binary outcome, this product will have a much higher correlation to the growth of the underlying in terms of return,” she said.

“This is why it will be very sensitive to the growth assumption we choose. There isn’t such thing with an autocall since all you need is a flat market to get you to a fixed payment. Here, the magnitude of the growth is key.”

Bull first

One scenario among the five is the most useful to investors for this type of product.

“Looking at the bull scenario is what makes the most sense. If you’re going to invest in equities, you expect positive returns,” she said.

In addition, the neutral scenario has limited uses when it comes to assessing probabilities of return outcomes, she said. In this report for instance the neutral scenario displayed a minus 0.2% growth rate for the underlying index.

Such result is not an anomaly, she explained.

“The growth rate is calculated as the risk-free rate minus the dividend. Both are quite similar, so of course, you’re getting a growth rate close to zero.”

Capping out

In terms of outcome, the bullish performance is also the one that brings the best performance, according to the table.

Investors will get the maximum return in this optimal scenario 43.5% of the time while this probability falls to 11.19% in the neutral and 0.73% in the bear market.

No gain, no loss

Symmetrically, the “minimum return” bucket, which is getting one’s initial investment back only, is the lowest in the bull scenario at 21.65%. This outcome, which is the worst one since it yields no gain, will occur 80.07% of the time in the bear market and 50.23% of the time in neutral. It results from the market finishing flat or down.

It’s worth asking why the bull market, which is supposed to go up, would produce the worst outcome as often as 21.65% of the time. Similarity why would this worst outcome due to a down or flat market occur 80% and not 100% of the time in a bear market.

Average, not target

“It’s a simulation. The growth rates we come up with are averages,” she said to explain what appears to be counterintuitive.

Another factor is the extremely conservative assumptions made for growth in each scenario, she added.

For instance, the model produces a growth rate of 5.3% a year in the bull market and minus 5.7% in the bear market.

“Assuming a 5.3% annual increase in the Dow Jones industrial average is an average. It’s not a target rate,” she said.

“There is still a range of returns around that, which depends on volatility. The simulation relies on a variety of factors, which introduce variance of distribution,” she said.

“It’s not as if we predicted a fixed 5.3% rate of return for the bullish scenario. It will vary.”

Neutral

The calculation of the growth rate shed some light on how to read the neutral scenario.

Investors have a 50.23% probability of getting only par at maturity. They will “cap out “11.19% of the time in this scenario. Hence, any positive return in the middle represents the difference, or 38.58%.

Adding the two positive buckets together, investors win 49.77% of the time. But they win nothing (worst case outcome) 50.23% of the time.

“It’s almost 50/50 and it’s to be expected,” she said.

“If you have a flat growth rate, the chances of being up or down are very similar. Since you can’t lose money in this note, it will be sort of an even distribution between gains and getting your money back,” she noted.

She warned however that the neutral scenario should not be used to make investment decisions, as it is more of a pricing reference than the basis of a simulation.

Bond substitute

To conclude, Hampson explained that the potential return outcomes should not be compared to an at-risk equity product.

“You don’t have any market risk, just credit risk, so clearly this product should be compared to a six-year bond issued by Credit Suisse,” she said.

“You’re simply giving up a fixed coupon for the chance of getting a higher return. That’s the trade-off.

“Since you run the risk of getting nothing at maturity, you are entitled to receive a higher premium than what you would get with a plain-vanilla bond.

“This is an alternative to a fixed-income instrument for someone who wants exposure to equity without the market risk.

BofA Merrill Lynch is the agent.

The notes will price in June and settle in July.

© 2015 Prospect News.
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