Credit Suisse’s Accelerated Return Notes on gold ETF show tactical bet on safe haven with risk

By Emma Trincal

New York, May 15 – Credit Suisse AG, London Branch’s Accelerated Return Notes due July 2021 linked to the SPDR Gold Shares fund give investors an alternative to a direct investment in the well-known gold fund in the hope of hedging a potential market downturn, but the lack of downside protection gives the structure a high-risk profile, said Tim Mortimer, managing director at Future Value Consultants.

The payout at maturity will be par of $10 plus triple any fund gain, up to a maximum return of 15% to 19%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be exposed to any fund decline.

“It’s a 14-month. It’s quite a short-dated product, but it’s not uncommon. Any tactical investment is going to be short,” Mortimer said.

Safe haven

“Investors in the notes are betting on equity having another bad year. It’s a safe-haven kind of tactical play in this environment,” he said.

The main characteristics of the notes aside from their short maturity are the high leverage, the cap and the fact that they offer no downside protection.

Sold under the brand name “Accelerated Return Notes,” those structures are popular within Bank of America’s distribution channel, according to data compiled by Prospect News. However, those “ARNs” tend to be linked to U.S. equity indexes rather than sector plays or different asset class. The SPDR Gold Shares fund, a commodity fund, is the largest physically backed gold ETF in the world.

Mildly bullish

“You wouldn't buy this if you were concerned about a downturn since you’re fully exposed to the downside,” he said.

“The strategy consists of capturing a 17% return if the underlying is up a little bit. You're betting on a modest increase in gold prices using the 3x leverage to amplify those gains.”

Mortimer picked a hypothetical 17% cap at midpoint of the 15% to 19% range.

“If you expect the asset class to go up above 17%, you're better off with the underlying itself.”

The notes are designed to offer an alternative to the ETF if the commodity goes up moderately.

“Your one-for-one downside is the same.

“It’s the upside that’s different. You’re giving up the unlimited upside for a leveraged return, but your gains are capped. That’s the tradeoff,” he said.

No dividends

Pricing a note linked to a commodity fund, such as gold, presents some differences compared to doing so based on an equity underlying carrying dividends, he said.

“It makes the product price higher, therefore the terms a bit less attractive than if it was linked to an index or stock of comparable volatility. But the difference is not so significant over 14 months,” he said.

That’s because the “no-dividend” factor has less impact on a shorter-dated note. Over the long term, the dividends used by the issuer to price the product compound into more buying power giving the notes better terms.

Risk tolerance

The unprotected downside requires investors to have a tolerance for risk. From a pricing standpoint, the lack of any downside protection is also a result of the short duration.

“A meaningful barrier like 80% would be too expensive for a short-dated note. The cap would be too low. It wouldn’t work,” he said.

Investors could expect an 80% barrier on a two- or three-year term or a 60% barrier over five years as the cost of putting a barrier decreases with time, he added.

Digital-like

The 3x leverage raises the chances of reaching the cap. With this note for instance, a less than 3%-a year increase in the underlier would be enough to allow investors to hit the 117% cap, he explained.

“When you get high leverage, your payout begins to be very similar to a digital,” he said.

“The notes cap the return at 117% when the underlier is at 103%. If it was an at-the-money digital, you would need to be above 100%. This structure makes it a little bit worse but it's not too far different.”

Loss probabilities

Future Value Consultants offers stress-testing on structured notes. A report ran on this product helped analyze the different return outcomes associated with this structure and their respective probabilities of occurrence using a Monte-Carlo simulation model. Each report consists of 29 different tests or tables. The firm offers simulation as well as back-testing analysis across four different market scenarios – bull, bear, less volatile and more volatile.

One of the tests, called “scorecard,” revealed that investors are expected to get the maximum return 38% of the time.

The chance of getting a positive return below the cap was 12%.

Finally, investors had a 50% chance of losing money.

The same table displayed an 85% average payout in the loss scenario, which is the equivalent of an average loss of 14%.

Smaller losses

Mortimer put the large probabilities of losses in perspective.

“You have to look at the average loss size not just the probability,” he said.

The average loss for this product was much smaller than figures found in barrier notes, he added.

“By definition when you breach a European barrier, you will lose at least the amount of the contingent protection, which can be a steep loss of capital,” he said.

“With a typical barrier note, your chance of losing money is lower. But you lose much more.

“This product is the opposite. You have a higher probability of losing money, but the losses are limited.

“You could lose as little as 1% for instance.”

Neutral versus bullish

In addition, the loss probabilities are based on the neutral scenario, a pricing tool used for the simulation in all reports.

“It’s off our neutral scenario, which doesn’t’ reflect real market conditions. It’s more of a pricing standard,” he said.

“If investors had to go with the neutral assumption of the model, they would never invest,” he said.

The bullish assumption displayed in a separate table improves the results somehow with a probability of losing capital at 35%.

The average loss is now at 12% instead of 14%.

“You have a big drop of probabilities between half of the time and one third of the time,” he said.

But because even the bullish scenario is built on very conservative growth assumptions, the average loss, now at 12% does not drop all that much compared to the neutral simulation, he noted.

BofA Securities, Inc. is the underwriter.

The notes will price in May.

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