Credit Suisse’s absolute return notes on Stoxx, EM fund fit non-directional bet, but beware EM

By Emma Trincal

New York, July 9 – Credit Suisse AG, London Branch plans to price 0% absolute return barrier securities due July 27, 2023 linked to the Euro Stoxx 50 index and the iShares MSCI Emerging Markets exchange-traded fund has a lot to offer to investors seeking exposure to international equities without knowing which way this market is going.

The worst-of payout comes with a deep barrier at 50% of the lesser performing index with a 1% for 1% absolute return if the barrier is not breached at maturity, according to an FWP filing with the Securities and Exchange Commission. If it is, investors will lose 1% for each 1% decline of the worse performing asset.

Bulls can also make money as the upside is uncapped in addition to a 125% to 130% participation in the gain of the worse performing index with no cap.

Yet, advisers were not eager to consider the notes. What kept them hesitant, despite the obvious appeal of the structure, was the iShares MSCI Emerging Markets ETF, whose volatility can deliver high returns or deep drawdowns.

Volatile fund

“That 50% barrier with absolute return is awesome. But with the emerging market ETF, you’re rolling the dice,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“And you’re talking five years out...I don’t even trust looking at five weeks.”

The Emerging Markets ETF shows a wide magnitude of annual returns, he noted.

In 2008 during the financial crisis, it dropped 50%. The next year, it jumped 72%.

“Even without those extremes, this ETF can be down consistently through a number of consecutive years. What scares me is not necessarily a big drawdown on a given year but instead death by a thousand cuts.

“You’re looking at a cumulative performance over five years. The only point that matters is the last year.

“So do I feel totally safe with a 50% barrier? With most indexes I would, but I wouldn’t say that about emerging markets,” he said.

It’s the economy

One thing is almost certain: if the market finishes down after five years, the emerging markets fund should be the worst performing asset of the two. But how negative could its performance be?

“It’s hard to evaluate on a five-year time horizon. The emerging markets one is going to be all over the place.

A lot will depend on the economy,” he said.

“If nobody comes to their senses and we get into a full blown trade war, Europe is going to hurt; the U.S. is going to hurt. But emerging markets are going to hurt even more because they sell to both. Those countries are almost completely export-driven, which makes it even worse for them,” he said.

Kunhardt said it is too soon to predict a long-lasting and devastating trade war. But risks of intensified protectionism are already being felt.

“It is definitely a possibility,” he said.

Big drop

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, shared the same concerns.

“It’s interesting. If the market ends up bullish, your worst-of will be the Euro Stoxx, and if it ends on the downside, your return will be tied to emerging markets. That’s how it’s likely to play out,” he said.

This forecast was based on the higher volatility seen for the ETF than for the euro zone benchmark.

“The EEM tends to trend strongly in both directions. When it’s trending up it does very well. When it falls it falls significantly,” he said.

He was referring to the underlying emerging markets fund, which trades on the NYSE Arca under the symbol “EEM.”

This represented a challenge on the downside despite the wide absolute return range from 50% to 100% of initial price.

The fund dropped 67% between its high in the fall of 2007 and the financial crisis a year later, he observed.

“I don’t think a 50% drawdown is outside the realm of reality,” he said.

“A recession could happen tomorrow or three years from now. But we’re bound to get one.

“The absolute return barrier is pretty nice. Being up 49% would be great.

“But if we hit a bad streak, if we have a big recession, it’s not going to be great.

“I guess it depends on what type of recession we have. If it’s a mild recession then the absolute return would be a return booster.”

Limited upside

Bulls should also be aware that just having an uncapped performance does not mean their upside won’t be limited.

“You have a worst-of. If the market is up, the Euro Stoxx will underperform emerging markets. You could end up losing a lot of upside if your return is tied to the worst-of.”

By definition, investors’ returns will be limited to the worst-performing asset.

For Chisholm the main issue was the worst-of payout.

“If I want to invest in emerging markets and take the downside risk of this asset class, I want the upside potential,” he said.

“Here I’m going to get the worst of the two on the upside and the worst of the two on the downside.

“I’d rather have a straight allocation to these two asset classes separately.

“They’re correlated enough they should move in a way that makes sense directionally. But the strength of their directions, the magnitude of their moves are very different, and this is a risk which should not be overlooked.”

Credit Suisse Securities (USA) LLC is the agent.

The notes will price on July 24 and settle on July 27.

The Cusip number is 22550WZU4.

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