Credit Suisse notes tied to S&P 500, long-term Treasury fund offer principal-protection, hedge

By Emma Trincal

New York, Feb. 1 - Credit Suisse, Nassau Branch's bull/bear principal-protected notes linked to the performance of a basket made up of the S&P 500 index and a long-term Treasury bond fund may appeal to investors seeking full principal protection as well as returns in both up and down markets, sources said.

Credit Suisse plans to price zero-coupon bull/bear principal-protected ProNotes due Aug. 27, 2015 based on the performance of a basket containing equal weights of the S&P 500 and the iShares Barclays 20+ Year Treasury Bond fund, according to an FWP filing with the Securities and Exchange Commission.

This iShares fund seeks to approximate the total rate of return of the long-term sector of the U.S. Treasury market, including Treasuries that have a remaining maturity greater than 20 years, are non-convertible, are denominated in dollars, are rated investment-grade, carry a fixed rate and have at least $250 million par amount outstanding.

The payout of the notes at maturity will be par plus any basket gain or par plus 40% to 50% of the absolute value of any basket decline.

Investors get par only at maturity in only one case: If the basket neither gains nor falls, according to the prospectus.

Credit Suisse is also readying another note identical in structure except for the tenor and participation rate. The notes are due March 3, 2015. The participation rate if the underlying basket gains is 110% instead of 100%.

The advantages of this structure are the principal protection and the fact that "the growth potential comes from the upside," wrote Suzi Hampson, structured products analyst at Future Value Consultants.

Averaging is key

Instead of measuring the performance of the basket from the trade date to the final valuation date, a method called point-to-point, the issuer averages out the performance of the basket each year.

"Averaging can restrain growth in a rising market," said Suzi Hampson in her firm's research report.

The prospectus described averaging as a risk as well, specifying that, "Your ability to participate in the appreciation of the basket may be limited by the annual averaging used to calculate the final basket level, especially if there is a significant increase or decrease in the level of the basket during the latter portion of the term of the securities or if there is significant volatility in the level of the basket during the term of the securities."

"Averaging is going to dump down your return," said a financial adviser. "That's how they're able to do it."

Averaging does lower the returns, said a sellsider. But it was the only way for the issuer to be able to finance a structure that offers attractive terms, such as a payout in up and down markets in addition to the principal protection, he noted.

"The key here is the annual averaging. It can make a huge difference in terms of pricing," this sellsider said. "If they had done it point-to-point, there is no way they could have made it work. The put would have been too expensive."

This sellsider said that the issuer is buying a put on the basket in order to give full or even leveraged return on any basket gain. "If they had done it point-to-point, they could have never bought the options. It would have been incredibly expensive," this sellsider said.

Financing the option

Sources said that the deal offers "attractive" terms to investors and that it is "interesting" to find out how the issuer had been able to finance it.

"Volatility is so low right now, the price of buying options is probably very low," said Wade Slome, registered adviser at Sidoxia Capital Management in Newport Beach, Calif. "Volatility has been coming down for a while. Sure it was up last week, but it's still way, way down."

"I guess the issuer will buy a bunch of options. If the underlying basket goes up, your put expires worthless. If it declines, you make money out of the puts, which you share with the investors," said Slome, referring to the payout offered on 40% to 50% of any basket decline.

The financial adviser cited earlier said that the inclusion of the long-term Treasury bond fund in the underlying basket is one element that allowed the issuer to reduce its cost.

"They're trying to do a principal-protected note exposed to the S&P. But they need something to mitigate the volatility of the S&P in order to be able to purchase the option," he said. "By introducing the Treasury fund, they reduce the underlying volatility of the overall basket, and therefore they're able to lower the cost of the option."

While the economics of the deal make sense, sources said they were not necessarily interested in offering the notes to their investors.

Mixing stocks, Treasuries

The financial adviser said that the underlying basket was his biggest objection to the structure.

"I don't understand how a long-term Treasury investor, by definition a risk-adverse investor, would want to take credit risk on the issuer for five years. Why take credit risk wrapped in a 20-year Treasury fund if you're risk adverse? You could get the principal protection directly from the Treasury securities or from a certificate of deposit," he said.

In addition, this adviser said that stocks and bonds tend to move in opposite directions. As a result, investors buying into a basket of equally weighted U.S. stocks and U.S. Treasuries would run the risk that they'd see the returns of those two components "offsetting each other," adding that "in such case, your basket is flat and your payout is zero."

But Slome objected to this view, saying that, "I don't think there is necessarily an inverse correlation between bonds and stocks. They could move in sync or not. There are many different scenarios possible."

However, he agreed with the notion that taking credit risk is not sound.

"You're taking the underlying credit risk of Credit Suisse for five years. Who knows what's going to happen in five years?" said Slome. "And who are they hedging with?"

"This doesn't mean that it's not a good deal," Slome added. "In fact, it could work for a specific type of clients. But personally I wouldn't offer it to my clients because I think I can structure these things myself at a lower cost using for instance an exchange-traded fund. Or if I am going to invest in an area where I think the risk is lower, I'd rather not pay for the insurance."

Others would say that there is a demand for those products.

"This investment derives from an asset-allocation model," said the sellsider. "These notes are for people who want to diversify between stocks and Treasuries. They don't have a strong conviction, but they want to participate in the market," he said.

The notes due Aug. 27, 2015 are expected to price on Feb. 23 and settle on Feb. 26. The notes due March 3, 2015 are expected to price on Feb. 25 and settle on March 2.

Credit Suisse Securities (USA) LLC is the underwriter for both products.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.