Credit Suisse's Bares linked to iShares MSCI EAFE offer 20% buffer but a five-year tenor

By Emma Trincal

New York, July 18 - Credit Suisse AG, Nassau Branch's 0% Buffered Accelerated Return Equity Securities due July 24, 2017 linked to the iShares MSCI EAFE index fund offer attractive terms for investors looking for long-term exposure to developed countries, in particular European equity.

But sources question whether the five-year duration is reasonable for a capital-at-risk product linked to a great extent to European stocks in the midst of the sovereign debt crisis affecting the region.

The payout at maturity will be par plus about 144% of any fund gain, with the exact participation rate to be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the shares fall by up to 20% and will be exposed to any losses beyond 20%.

The deal offers unlimited and leveraged upside and attractive protection against market downside risk, noted a market participant.

"You can't get those terms with a 20% buffer on a one- or two-year [note], you just can't," he said.

Make it long

The implied volatility of the underlying exchange-traded fund (listed on the NYSE Arca under the symbol "EFA") is 23%, a structurer noted.

"It's significantly higher than the S&P [500]," he said. The CBOE Volatility index, or VIX, which measures the implied volatility of the S&P 500 index options, is currently 16.

"You're buying volatility with the leverage and selling a put to create the buffer. You're buying 1.44 at-the-money calls for every put you're selling. So in order to buy optionality, you have to go out in duration," he said.

Plagued by record-low interest rates, issuers have to extend duration in order to make their deals more attractive, this source said.

"When you think about it, you have an uncapped structure, which is great, plus the leverage. But you're in for five years, and 80% of your capital is still at risk. A 20% buffer is not that much for that type of term," he said.

Investors considering the notes should also have a long-term perspective.

"In five years, you'd expect the market to be higher. Then you have to wonder whether you should spend all your money to buy protection. Maybe you ought to look at buying more leverage instead," he said.

Credit risk

Eric Greschner, portfolio manager at Regatta Research & Money Management, said that he likes the underlying theme as he is bullish on European equity. But the five-year maturity, he said, is a drawback.

"This is longer compared to what we've seen," he said.

"It may be a little bit too long for our taste. We would prefer two years.

"On a five-year, credit risk becomes a greater concern. We may not be so concerned about it if it was a U.S. issuer, for instance a Bank of America or JPMorgan. In fact we may be inclined to consider this product if it was offered by one of those issuers. But to have exposure to the European market and a European issuer may be a bit much," he said.

Credit Suisse has an A+ rating from Standard & Poor's.

Market participants also weighed the market risk posed by a long-term investment in the iShares MSCI EAFE index fund.

Step by step

Greschner said he sees in Europe a great buying opportunity. He added that he is in the process of increasing his allocation to international large-cap equity, including Europe, while decreasing his exposure to the S&P 500 index.

"We are considering investing in the EFA from a valuation standpoint. We don't think the euro zone is going to break up, and this is based on our own research and our analysis of the institutional research we have access to. We see the European market as a short-term reversion to the mean valuation play. That's why five years would not match our short-term strategy," he said.

The ETF has lost 2% year to date but is down 13% for the last 12 months.

Since early June, however, the fund has recovered slightly and is up by more than 4%.

"What worse can go wrong in Europe? Many believe we may have reached the bottom," the market participant said.

Greschner said that he is contemplating getting direct exposure to the ETF in three steps.

"First a 20% downside protection would give us confidence and we would get some leverage. Then as we get closer we would rotate into something that gives us maybe a 10% buffer with a greater upside. At the third stage, we would buy the maximum leveraged upside with no buffer or barrier on the downside," he explained.

For contrarians only

Other investors are not that enthusiastic about Europe and developed countries in general.

"It's hard to make a case for investing in the developed markets, especially in Europe right now, unless you are a serious contrarian," said Greg Werlinich, president of Werlinich Asset Management, LLC.

"There's no clear picture of what's going to happen to the sovereign debt of the euro zone countries. Is Angela Merkel going to tell Germany to support the entire European Union at the expense of Germany in order to keep the euro zone alive? Who knows if there's even going to be a euro five years from now.

"Recently, I've reviewed some of my clients' allocation to Europe and I've been eliminating entirely or dramatically reducing that exposure."

Credit Suisse Securities (USA) LLC is the underwriter.

The notes will price Monday.

The Cusip number is 22546TWM9.

As of May, stocks of companies from the greater Europe region accounted for nearly two-thirds of the MSCI EAFE index. Euro zone countries amounted to a third.

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