Credit Suisse’s worst-of contingent coupon callable on indexes offer equity substitute

By Emma Trincal

New York, Sept. 15 – Credit Suisse’s worst-of three-year notes linked to three equity indexes offer the risk reward of an equity substitute, a financial adviser said.

The relatively high coupon and low barrier are compelling, another source said, as a result of the additional risk introduced with a third underlier as opposed to the most common use of two.

Credit Suisse AG, Nassau branch plans to price contingent coupon callable yield notes due Sept. 20, 2019 linked to the S&P 500 index, the Russell 2000 index and the Euro Stoxx 50 index, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will pay a contingent quarterly coupon at an annual rate of at least 9.1% if each index closes at or above its barrier level, 60% of the initial level, on the observation date for that period.

The notes will be callable in whole but not in part at par plus the contingent coupon on any quarterly interest payment on or after Dec. 20, 2016.

The payout at maturity will be par unless any of the indexes finishes at or below its 60% knock-in level, in which case investors will lose 1% for each 1% decline of the worst-performing index.

All-time highs

“I like these kinds of deals. We’ve done quite a few worst-of as fixed-income substitutes when the market was not fully valued as it is now,” said Steve Doucette, financial adviser at Proctor Financial.

“But now, I tend to use them more as equity substitutes because there’s a greater probability that we’re going to have a correction or a bear market given how long we’ve been in that bull cycle.

But he added that the risk-reward of this deal was very attractive.

“You’re going to get 9% a year. This is an equity return. The only way you’re not going to get it is if the market tumbles 40%. The risk-reward is pretty good,” he said.

However, investors would have to assess the risk of breaching the barrier based on today’s market levels.

“What are the chances you’re going to hit the barrier and be down 40%? That’s a risk you would have to assess. That’s why I wouldn’t do this as a fixed-income substitute. As an equity replacement? Yes.”

Cushion, not buffer

Doucette said that investors were likely to collect some of the contingent coupon payments.

He gave an example: Assuming an investor would collect two years in a row of the 9% annualized coupon and that at maturity the market would drop 40%: the investor would have an 18% cushion obtained from his coupons, which would reduce his loss of principal at maturity to 22% instead of 40%.

“If you believe the market is not going to go all the way up and not down 40%, this lets you capture a 9% return. If you do burst though the barrier, you still have a nice cushion,” he said.

Volatility

One reason why the issuer was able to offer a 9% return, he said, was because the worst-of was structured around three underlying indexes while the standard product only uses two.

“Of course, it creates more risk and therefore more premium,” he said.

“But you have to look at the historical returns.”

Volatility and correlations also mattered, he noted.

With a worst-of note, the less the underlying assets are correlated, the greater the risk.

He compared the returns of the three indexes during the year of the last financial crisis in 2008. The Euro Stoxx 50 index was down 45%.

It would have been the worst performing index and the only one to breach the barrier. Both the S&P 500 and the Russell 2000 indexes down at minus 37% and minus 34%, respectively, would have closed above the threshold.

Correlations

“It seems like the S&P and the Russell are pretty well correlated. Those two are the ones that have been running up in the past few years,” he said.

Because two of the three indexes were highly correlated, investors could look at the three underliers as two asset classes – U.S. and European stocks – and determine according to their own analysis whether the exposure would tilt toward the U.S. markets or the Euro Stoxx, he said.

Doucette concluded that the notes would not be suitable for fixed-income investors given the risk.

“But I can see it fitting nicely in an equity portfolio,” he said.

No, thank you

Another registered investment adviser said the deal was very tempting given the low barrier level and the high coupon. But he would not be buying the notes.

“Oh Gosh! We don’t do too often the worst-of...the reason being I sort of hate that cliff idea.

“Anyone of the three hit the barrier...and that’s it! It’s pretty risky,” he said.

Investors often use the term “cliff” to designate a barrier, distinguishing it from a buffer. Once the barrier is hit, the protection is removed, unlike buffers, which at least guarantee a small portion of principal.

“The difficulty you have of planning other positions of the portfolio around it if we have that kind of disaster scenario would keep us away from it,” he added.

This RIA said that he keeps his notes tied to one underlier only.

“At least we try.

“Again I can understand why this product is attractive: you get much better terms playing with the correlations. That’s how they can offer such a great return.

“But we would be a bit too nervous about this cliff.”

Credit Suisse Securities (USA) LLC is the agent.

The notes (Cusip: 22548QHK4) are expected to settle on Tuesday.

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