Credit Suisse's knock-out notes tied to Euro Stoxx 50 offer attractive trade-off, sources say

By Emma Trincal

New York, Oct. 10 - Credit Suisse AG's 0% knock-out notes due Oct. 17, 2018 linked to the Euro Stoxx 50 index give bullish investors a valuable trade-off with a real chance of outperforming the index both on the downside and the upside.

A knock-out event occurs if the final index level is less than the initial level by more than the knock-out buffer amount, which is expected to be 40% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If a knock-out event has not occurred, the payout at maturity will be par plus 160% of the index return, subject to a minimum payout of par. The exact upside leverage factor will be set at pricing.

If a knock-out event has occurred, investors will be fully exposed to losses.

Investors in this product enjoy a leveraged upside without any cap as well as up to 40% in downside protection delivered through a barrier, sources said. The less attractive features are the five-year tenor and the lack of dividends from a high-dividend paying index, which offers a 2.91% annual yield, they noted.

Buy-and-hold

Investors who are bullish and willing to stay invested for the long term would benefit from the trade-off, said Tom Balcom, founder of 1650 Wealth Management.

"For a buy-and-hold investor, it makes a lot of sense. The 40% protection is worth it," Balcom said.

While the protection is not a buffer, Balcom said that the 40% threshold is "very reasonable."

"If the index finished down 41%, investors would lose 41%. But the rest of the portfolio would have serious problems too. This position wouldn't be the only concern," he said.

Investors would have to be willing to hold the notes until maturity.

"If the index was up after one year, the notes' pricing would not reflect the appreciation of the option. You wouldn't get one for one. That's why this is not designed to be sold prior to maturity. It's what issuers often recommend in the prospectus. But the client has to understand this," he said.

Leverage versus dividends

Investors in the notes incur a sizable opportunity cost given the high dividend yield they are giving up. But the leverage makes up for the loss, at least after a certain level of growth.

"That's why you have to be quite bullish if you want to buy this product. You should expect solid growth. If the index performance is small, most of the return would come from the dividend, and in that case, your notes would underperform," Balcom said.

"Under a solid growth scenario, the leverage in the notes gives you the opportunity to outperform the index.

"But if the return is modest, the leverage may not be enough to offset the loss of dividends."

For Balcom, getting the protection is a valuable trade-off. But the notes are not for everyone. Purchasers of the notes would have to be buy-and-hold investors with an aggressive bullish outlook.

"For a buy-and-hold investor who is comfortable with a five-year note, it accomplishes a goal," he said.

"Yes, you give up the nice dividends, but you get the protection, which is what my clients are looking for. They tell us, We don't just need those notes for the upside, we also want the downside protection.

"This one gives you both.

"The 1.6 leverage allows you to recoup the loss of dividends.

"You're only going to lose if the index is flat. The whole point is to have the downside protection."

Wide range

Getting leveraged and uncapped upside along with a low barrier is an appealing combination, said Steve Doucette, financial adviser at Proctor Financial.

"The no cap is really good. It's a pretty straightforward note. I am surprised you can get no cap. Volatility has been up. That's why you're getting a better barrier and a wider range," he said.

The loss of dividends is not a real concern in his view given the leverage.

"You only need 1.8%, 1.9% to really capture that dividend because that 1.6 leverage will get you that extra point," he said.

"Over five years, the dividend return is 14.5%. A 9% return is your crossover. The 9% return over the period will make up for the dividends based on the leverage.

"You get a wide range on the downside and the upside. It's a nice straddle on the index.

"You have a lot of protection and a lot of leverage."

Shorter version

If one piece of the structure could be changed, it would be the tenor, he said.

"A shorter duration would be good," he said.

"Over five years, you don't know where you'll be in the cycle.

"We're already nearly five years into a bull market. Theoretically, we should have a change of market direction soon. If we had a bear market, the market may turn back as you get to the end of the term. But you could also have a continuation of the rally for a while with a bear market kicking in at the end. That's the scary part. Forty percent might be just enough to get you through that.

"It's too hard to tell which way the market is going and when. That's why we typically keep our notes short.

"I'd be curious to see what the terms for a shorter duration would be. We'd have to take a look and see where it falls. It would be interesting to see if we could get that type of leverage with a reasonable amount of protection for the next two years."

Bull play

For investors bullish on European markets, growth is the most appealing feature of the deal, but the protection is also necessary given the risk.

"I like the Euro Stoxx index," said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

"This does appear to be a very attractive note to me. The restructuring that has taken place in Europe over the past few years offers growth opportunities to investors.

"I am very comfortable with the five-year period, and I like the fact that there is no cap on the upside.

"We've seen changes in Europe in the last few years that make me very confident, especially with a 40% downside protection.

"A clear direction from Draghi is critical for the stability in the region," he said, referring to Mario Draghi, president of the European Central Bank.

"Some of the issues from troubled countries - Italy, Spain, Ireland, Greece - are being addressed. Many of the problems still exist, but things have significantly improved.

"It's a matter of trade-off: dividends versus protection.

"Would you like to have direct participation in the Euro Stoxx and receive dividends but also be exposed to risk? Or would you rather forego the dividend and have a significant portion of the risk borne by the issuer?

"With a growth asset class like the European equity, I do believe that sharing the risk is going to be important.

"There is a risk with both emerging and mature European economies. But you're doing this type of investment for growth as opposed to the dividends.

"If you're bullish over the next five years, this is a pretty good investment in Europe."

The notes (Cusip: 22547QCA2) are expected to price Friday and settle Oct. 17.

J.P. Morgan Securities LLC and JPMorgan Chase Bank, NA are the placement agents.

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