Credit Suisse’s absolute return barrier notes tied to Euro Stoxx target cautious bulls

By Emma Trincal

New York, March 9 – Credit Suisse AG, London Branch’s 0% absolute return barrier securities due March 11, 2021 linked to the Euro Stoxx 50 index should appeal to bullish investors who want to profit from a limited downturn in the European market, said Tim Mortimer, managing director at Future Value Consultant.

If the index finishes at or above its initial level, the payout at maturity will be par plus at least 167% of the index return, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls but finishes above the 75% knock-in level, the payout will be par plus the absolute value of the index return.

Otherwise, investors will lose 1% for each 1% decline.

Terms

“This is quite a good product. The terms are attractive,” Mortimer said.

“You have a very high participation and it’s uncapped. That’s a good thing for bulls.

“On the downside you get 100% of the absolute return on the first 25% of decline... then of course it’s the standard one-for-one loss if it’s below the buffer.”

In general, notes linked to the eurozone benchmark tend to offer better terms than the S&P 500 index, he noted. That’s because interest rates in Europe are lower and dividends higher than in the United States.

“The forward is less expensive. It’s the futures market and the options market that drive pricing. So technically, the pricing conditions are more favorable on this index than on the S&P. That’s how you can achieve better terms” he said.

Barrier type

Absolute return notes allow investors to have two opposite views on the market. What matters is a limited index decline.

“So you do have some sort of trade off,” he said.

For instance the absolute return barrier is more attractive to investors than a standard barrier or buffer, all things being equal.

“Instead of getting just par, you make a profit. So in exchange you probably get a little bit less leverage than if your protection only repaid you your principal.”

Future Value Consultants provides full stress test reports for structured notes. Each report contains a maximum of 29 sections (or tables) its clients can choose from and combine based on what they are looking for.

Outcomes

The capital performance tests section shows the probability of each of three outcomes (return more than capital, return exactly capital, return less than capital) to occur.

“With this note, investors will either lose money or make a profit,” he said.

The “return exactly capital” bucket as a result shows a probability of zero.

On the other hand the probabilities assigned to the “return more than capital” bucket are the greatest at 70.62% in the base-case scenario, also called neutral.

“It’s the combination of index appreciation and any decline of less than 25% that contributes to profits,” he said.

Market assumptions

The 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 distribution assumption sets are also part of the simulation. They represent four additional market scenarios, which are based on volatility as well as different growth rate assumptions. Those are bull, bear, less volatile and more volatile.

In the bear scenario, investors have a 50.56% chance of getting more than principal, according to the table.

“Even in the bear, it’s still pretty good,” he said.

“It’s just because you can make money if the market is up or down. This probability would be much lower if it was a standard note that only pays when the index is up.

Naturally the bull scenario is the one that shows the greatest likelihood of getting a positive return with an 86.12% probability.

“If the market is up, the chances of finishing deep below zero are not very high,” he said.

Average payoffs

The capital performance tests also feature information on the average payoffs for each market scenario.

The highest at 137.4% is found in the bullish scenario.

The market environments which will pay the least are the bear scenario and the less volatile scenario, each showing an average payoff of 117%.

“You can evidently make money in a down market with this structure. An average of 17% return is not bad,” he said.

Since the upside is uncapped, the not very volatile market does not stand to benefit the most from the structure, he said.

Looking back

Future Value Consultants also provide back testing analysis over different time frames – last five, 10 and 15 years. Results are usually better for the most recent time horizon since the bull market was stronger over the most recent years, which have not felt the impact of the 2007-08 financial crisis.

The back testing measures the frequency of occurrence of each outcome, not their probabilities.

In the past five years, investors would have received more than capital all of the time. The frequency decreases to 76% and 74% for the last 10 years and 15 years respectively.

In terms of losses, the frequency is none for the last five years.

“Again this is because of the strong bullish trend of the past few years,” he said.

Over the last 10 and 15 years, the distribution changes and slightly increases to 23.83% and 25.89% respectively, according to the table.

The big picture

“But investors should not only focus on occurrence. They should look at the size of any return,” he said.

He pointed to an average payoff of 130.2% in the “return more than capital” bucket versus 138.6% in the last 15 years.

“Even though you have a greater frequency of gains in the last five years than you have over the past 15 years, your gains will be smaller in average at 30.2% versus 38.6%,” he said.

This was in part due to the volatility of the index.

The same volatility pushes up the average loss (34.2% and 38% for the 10-year and 15-year periods respectively) while the frequency of losses is only about 25%, which is relatively favorable to investors, he noted.

“You need to take a look at that. You need to see what your return is likely to be, not just your chances of getting it,” he said.

Tough trade

Absolute return notes are popular among investors but difficult for the banks to hedge.

“From the bank’s perspective, hedging the Euro Stoxx with this type of structure is challenging,” he said.

“There is a discontinuity of payoff. If on the last day the index flips...say it’s around the 75% level, the bank will have a lot of risk to hedge. You could have a small change in the index causing a 50% change. It can be a hedging headache for the desk.

“But I guess this particular scenario is not that common and investors do like the concept of absolute return. So that’s why you see them.”

Credit Suisse Securities (USA) LLC is the agent.

The notes will settle on Monday.

The Cusip number is 22550WJ40.

© 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.