Credit Suisse’s digital barrier notes tied to Euro Stoxx show most likely risk in time decay

By Emma Trincal

New York, April 12 – Credit Suisse AG, London Branch’s 0% digital plus barrier notes due April 29, 2024 linked to the Euro Stoxx 50 index gave financial advisers pause when trying to assess the risks and rewards of the strategy embedded in the product.

Both the upside return and the downside protection were appealing, they said. So what was the trade off?

The risk of not making money after a long time frame seemed to be the answer.

If the index finishes at or above its initial level, the payout at maturity will be par plus the fixed return of between 105% and 115%, according to a 424B2 filing with the Securities and Exchange Commission. Advisers chose a hypothetical digital return of par plus 105%, which is the equivalent of 12.7% per annum on a compounded basis.

If the index falls but remains at or above 60% of its initial level at maturity, the payout will be par.

Otherwise, investors will be fully exposed to any losses.

Decision tree

Steve Doucette, financial adviser at Proctor Financial, looked at the upside potential first, which was the easiest part to analyze.

“It seems intriguing at first. The return seems phenomenal. And even though you lose a high-paying dividend, it’s unlikely that you would get that type of return if you bought the index fund. The odds are pretty low that you’re going to consistently be up more than 13% for six years,” he said.

If the index performance was moderately bullish, the return offered by the notes would even significantly outperform a long position, he added.

The structure on the downside raised more questions.

Breaching the 60% barrier level was unlikely, he said.

More probable was a scenario in which the note would only return 100% of the investor’s principal.

“What if you’re down and you made nothing?” he said.

“What happens if the Euro Stoxx goes up 34% for two years and after that you have a bear market and you finish negative in that 60% to 100% range?

“You just get your principal after six years. No dividends, no interest. Worse: you haven’t been able to capture the 34% return of the first couple of years.”

Asset allocation

Doucette said he would not consider the notes. Many scenarios were possible but his reason was simple: the investment strategy did not match his asset allocation process.

“This is an intriguing note that might reap huge rewards. But you have to be willing to lock it up for six years,” he said.

“I’m am asset allocator and asset allocation is a process. I don’t like the illiquidity of this note. You can’t sell it. It’s not fully valued to the underlying index. So you can’t rebalance your portfolio either. When you are an asset allocator you need to rebalance in a consistent way.”

He offered an example: an investor has a 10% position in the notes. After two years, the Euro Stoxx 50 index is up 34%. As a result, 3.4% of the portfolio needs to be reallocated.

“I can’t take that 3.4% profit off the table and rebalance. Say the Euro Stoxx is going through the roof. Meanwhile the S&P is down. Do I want to continue to ride the Euro Stoxx that’s already up 34% and not rebalance my allocation to the S&P? I don’t.”

Gray area

Jeff Pietsch, head of capital markets at the Institute for Wealth Management, said the upside scenario was attractive but the risk associated with the time horizon of the notes was too high a price to pay for it.

“We’re bullish on European equities overall,” he said.

“To be able to lock in 12.5% sounds exciting. Most U.S. clients expect 8% to 10% on their investment.

“But as bullish as we are, six years is a long period of time.”

The most probable risk was if the index fell but ended above the barrier, he said, agreeing with Doucette on that point.

“I’m not overly concerned about the barrier being breached although it’s still a risk.

“I’m more worried about the opportunity cost. The market could run up and run down and you have tied up your money for six years without any gain. That’s a very long time.

“You have a decent probability of getting that 12.5% a year and that’s great.

“But I don’t have a crystal ball.”

Potential clients

Before recommending an investment, advisers need to make sure the product is suitable for their clients.

“This one is tricky. Obviously it’s far from being a bad deal. And yet, I’d be very hard pressed to think of a client this would be appropriate for,” he said.

A bullish investor would not consider it.

“They would buy the ETF outright,” he said.

A conservative client would look for a more predictable return, he added.

“So it’s hard to see who would look into it. It would have to be determined by your timeframe. This is for someone with a long-term bullish view on the index.”

The depth of the barrier mitigated some of the risk without eliminating the main one which is to miss the payout without losing any principal.

“It’s a very interesting deal but it’s a long time to wait to find out if it’s going to be a successful investment.”

Sophisticated product

Pietsch said he would “probably stay away from this,” preferring more conservative ways of generating a fixed return.

“There are too many opportunities to guarantee some yield. I’d rather have a constant yield, even at a lower rate,” he said.

The notes could be more suitable to other types of investors.

“It’s easier to imagine an institutional investor that is able to sustain the illiquidity and has a long-term perspective being interested in this product.

“The required sophisticated analysis you need goes beyond what makes sense for an individual investor.”

Some like the timing

Another adviser with a bearish short-term outlook liked the timeframe of the notes as it matched his view.

“This is pretty good with a lot of upside potential,” this adviser said.

“Six years is a good timeframe. The market will be relatively high by then,” he added predicting a bear market over the short term and within the next two years.

The drawback of the notes was the opportunity cost.

“There is a possibility that European stock markets fall so much during the next two years that they have not fully recovered after six years, so you will end up flat and give up six years’ worth of interest,” he said.

“But because the barrier is so deep and because 105% is such a high return, it’s still worth taking the risk.”

Credit Suisse Securities (USA) LLC is the agent.

The notes will price on April 20.

The Cusip number is 22550WNH6.

© 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.