Credit Suisse’s 8.5% STEP Income Securities tied to Sony are good for hedging or profit-taking

By Emma Trincal

New York, May 18 – Credit Suisse AG’s upcoming 8.5% STEP Income Securities due June 2016 linked to the American Depositary Shares of Sony Corp. offer a covered-call-like strategy for moderately bullish investors or stockholders eager to protect their profit given the strong run of the security, sources said.

If the price of Sony shares finishes at or above the step level, 108.5% of the initial price, the payout at maturity will be par of $10 plus a step payment of 1% to 5% that will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the stock return is zero or positive but the share price finishes below the step level, the payout will be par.

Investors will be fully exposed to any losses.

Resistance

“This is a covered call strategy,” said Kirk Chisholm, wealth manager and principal at Innovative Advisory Group.

“The deal is hard to evaluate because we don’t have the value for the extra income. We get a range between 1% and 5%. Let’s take 1%. If the stock goes above the step level, you make 9.5%, or close to 10%.”

He noticed that the share price has been rising significantly, up nearly 60% for the year. In the last 12 months, the stock has nearly doubled in price.

“The stock has been running up in the last year, most of it in the last few months,” he said.

“From a technical point of view, back in February 2011 the stock reached a high of $36.50 a share. The share price is now at $32.50. It’s reasonable to expect that it will hit the resistance point of $36.50.

“If that’s your strike in the covered call, you capture approximately four points, which is where the resistance should be.

“But I’m not sure I see any advantage in doing this note as opposed to a covered call.

“If you think the stock has limited room to go up, you’re writing a call. You have much more liquidity.”

Calls

Chisholm looked at at-the-money call option contracts for an equivalent one-year timeframe. There were no one-year contracts, so he chose the calls expiring on Jan. 15, 2016, eight months from now. At the $32.50 at-the-money strike, a covered call seller would receive for that timeframe a $3.50 premium. Since the investor bought the share outright when initiating the trade, Chisholm subtracted the $0.50 intrinsic value to keep only the $3.00 time value associated with the option contract. Dividing the $3.00 received premium by the price of the shares, which are purchased outright, the investor obtained a 9.23% return for eight months, or 13.85% on an annualized basis.

“You are already ahead of the game with the covered call,” he said, comparing this yield to the 9.5% best possible return on the notes, based on his conservative assumption of a 1% step payment.

“If you’re moderately bullish, you can orchestrate a covered call strategy around the price,” he said.

“The option is more liquid. If you change your mind, you can always get out or roll the contract. It’s much more flexible.

“Some structured notes have a real appeal. They give you an attractive risk-adjusted return. But I don’t know what the advantage is with this one versus a covered call.”

Hedging

Paul Weisbruch, vice president of ETF and options sales and trading at Street One Financial, said the notes make sense for investors in search of a hedge.

But “resisting greed” could of course have a cost if the rally has not yet run its course.

“If you’re already long the stock and concerned by the limited upside given how much the stock has gone up already, you can certainly use this as a hedge,” he said.

“It’s went up 33% in the first quarter.

“Obviously this stock is going to be sensitive to the next event, especially earnings, or even exogenous events.

“Anyone who had this profitable ride would consider locking in some profits, selling calls against the position or buy some puts just in case.

“Obviously when things do so well, hedging tends to be the smart move.

“In that regard, the strategy offered by those notes makes sense.”

Institutionally induced rally

But the strong uptrend seen for Sony has to be explained in the broader context or an institutional Japanese rally.

“Look at what’s behind the rising stock price. This stock moves in correlation not just with the sector but with Japan as a whole,” he said.

“Japan has done very, very well generically.

“If you compare the iShares MSCI Japan ETF and Sony, they’re pretty correlated. The ETF didn’t have such a huge run, but it’s still up 20% for the year.”

The S&P 500 index in comparison has gained only 3.5% this year.

While it’s always a good idea to hedge and to be cautious, Weisbruch said that a case could be made for “greed” due to the factors behind the bull market in Japanese stocks.

“Late last year, the Bank of Japan announced that it will be buying ETFs. The Bank of Korea made the same announcement. They’re not shy about it. Funny thing, these announcements did not get a lot of coverage.

“In the spring, the Bank of Japan made statements that they would be more active in the open market in April or May. In reality, they had already started in February.

“We also know that Japanese pension funds and Japanese banks are piling in Japanese ETFs and stocks.

“If I had to guess, the Japanese QE has been very successful so far if you judge it by what the stock market has done,” he said, explaining that the Bank of Japan does not just buy bonds but also equities.

He said that in May of last year, the WisdomTree Japanese Equity fund had $16 billion of assets under management. Since then, an extra $4 billion has been added to this amount.

“Only central banks or big pension funds have that kind of purchasing power.

“With all this institutional money out there, the dips are always bought and the market keeps on going to now highs.

“Long term of course this whole thing could blow up, but in the meantime this is a very rewarding rally.

“Investors in the notes have to be willing to take their profit and overcome greed.”

The notes are expected to price in May and settle in June.

BofA Merrill Lynch is the agent.

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