Credit Suisse’s leveraged notes linked to S&P Regional Banks offer narrow exposure to financials

By Emma Trincal

New York, Feb. 6 – Credit Suisse AG’s 0% Accelerated Return Notes due April 2016 linked to the S&P Regional Banks Select Industry index offer investors exposure to a niche market in the U.S. banking sector with a chance to outperform the index in a modestly bullish scenario, sources said.

If the final index level is greater than the initial level, the payout at maturity will be par plus 300% of the return, subject to a cap that is expected to be 18% to 22% and will be set at pricing. Investors will share in any index decline, according to a 424B2 filing with the Securities and Exchange Commission.

Not often used

The underlying index measures the performance of the regional banking segment of the U.S. equity market. It includes 84 index components, with an average market capitalization of about $3.8 billion.

Its top three constituents are City National Corp., SVB Financial Group and First Republic Bank.

The index was launched in September 2011. It has only been used three times before in registered structured notes, according to data compiled by Prospect News.

The most recent one was Credit Suisse AG, London Branch’s $9.1 million of 0% Accelerated Return Notes due Jan. 29, 2016 tied to this index. It priced on Nov. 25, and BofA Merrill Lynch was the underwriter.

Deutsche Bank AG, London Branch in July issued $9.91 million of 0% autocallable securities due July 29, 2016 linked to the SPDR S&P Regional Banking exchange-traded fund.

Finally Deutsche Bank on Oct. 15, 2013 sold $3 million of 0% digital optimization securities due Oct. 23, 2014 linked to the SPDR S&P Regional Banking ETF. UBS Financial Services Inc. was the agent.

Low interest rates

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the current market environment may not be favorable to smaller banks.

“Regional banks are going to have a bit of a challenge due to the low interest rate environment primarily. I think that it’s a headwind for the smaller banks,” Medeiros said.

“Obviously there is risk in this particular sector. That’s probably why there is so much leverage in this kind of product. The goal is to enhance the returns of what’s anticipated to be a relatively low performance.

“Anytime you have lower interest rates, it’s hard for banks to make money. Their margins are being compressed.”

Medeiros said that the notes deliver a “very specific sector bet” but that he was not sure what the catalyst would be for the trade.

“It seems to me that investors in the notes want exposure to the financial sector with a focus on banks and they have a preference for the regional banks as they anticipate a little bit less headwinds in this space. They want to make an intelligent bet on banks with a focus on mid- and small-cap names.

“It still looks like there is volatility in this play. But if you don’t mind the cap, if you’re just slightly bullish, you can take advantage of the leverage opportunity.”

One benefit of getting exposure to the regional banks sector is diversification, Robert Goldsborough, an ETF analyst at Morningstar, wrote in a recent research note.

“[The regional banks’] performance generally is less correlated than that of national money-center banks. Unlike the mega-banks, regional banks' performance is more closely tied to the health of their local markets, which can vary meaningfully. As a result, this exchange-traded fund can offer diversification benefits. KRE makes best sense as a tactical satellite holding,” he wrote.

The SPDR S&P Regional Banking ETF is listed on the NYSE Arca under the symbol “KRE.”

Volatility

Clemens Kownatzki, independent currency and options trader, said the notes are risky due to the underlying volatility of the index and the 14-month duration.

“I can’t seem to find a great reason to want to make this investment,” he said.

“On one hand, it’s interesting to have the 300% upside participation. But you have no protection on the downside and no liquidity. That’s a concern to me.

“And then why the choice of this particular underlying? It’s not clear to me.”

He added that the performance of the index does not necessarily show a bullish trend.

Last year, the index was flat. So far this year, the return has been negative, down 9.6%, according to Standard & Poor’s website.

“I can’t see the benefit of getting exposure to regional banks rather than investing in the broader banking or financial sector,” he said.

“Banks are facing a lot of challenges due to low interest rates. Loan yields have dropped so much. The big banks are not lending because lending has become complicated and costly.

“Each bank needs compliance. A compliance officer will cost a bank $500,000 a year. If you’re a community bank, you can’t afford that. You get rid of the riskier business and concentrate on less lucrative activities. Regional banks don’t have the facilities, the staffing, the infrastructure that big banks have, and yet they are subject to the same sets of rules.”

Goldsborough in his report made a similar point.

“Some regional banks may lack sufficient scale to match larger banks' cost efficiency, which may make them less competitive in a low-interest-rate environment,” the analyst wrote.

Liquidly, protection

Kownatzki said he would much prefer investing in the SPDR S&P Regional Banking ETF.

“Anytime I invest in a structured product, I look at all the alternatives, all the different instruments in the space,” he said.

“What am I investing in, and what’s the downside? What’s the duration risk? If the index goes down, how do I get out of it?”

One of the selling points of the structured note, he conceded, is the asymmetric leverage. Investors get three-to-one exposure to the upside, but there is no leverage on the downside.

“It’s true that it can be an advantage. If you bought the ETF on leverage, you would get three times on both sides,” he said.

“Still. It’s not worth giving up the type of liquidity I would get from the ETF.

“And if I really want to replicate this feature, I could do it with options strategies, although it takes some skills.”

Kownatzki said the volatility of the index is another reason why he would opt for more liquid alternatives.

“You can always redeem your note, but at what price? This is a relatively volatile index. The one-year implied volatility is 22% versus 14% for the S&P,” he said.

“And there are tricky patterns. In 2007, the ETF was trading at $40. Now it’s trading at $40. No move. Last year, it really went nowhere. Yet, it had some very wide swings.

“When you see that type of volatility, you want to be able to get out.

“I can always use options to eliminate the downside leverage. Or I can use a simplistic trading strategy ... leverage with a stop on the downside. It’s not exactly the same as what you get with the notes, but I protect my downside.”

The notes are expected to price in February and settle in March.

BofA Merrill Lynch is the agent.

© 2015 Prospect News.
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