Credit Suisse’s contingent coupon notes on biotech, energy ETFs show American barrier risk

By Emma Trincal

New York, Oct. 15 – Credit Suisse AG, London Branch’s contingent coupon autocallable yield notes due Nov. 5, 2021 linked to the lesser performing of the SPDR S&P Biotech exchange-traded fund and the Energy Select Sector SPDR fund offer an attractive yield, but the risk involved for investors is much too high, sources said.

Each quarter, the notes will pay a contingent coupon if each ETF closes at or above its knock-in level, 60% of its initial share price, on the observation date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The contingent coupon rate is expected to be at least 12.75% per year and will be set at pricing.

Beginning April 30, 2020, the notes will be automatically called at par if each ETF closes at or above its initial share price on any quarterly observation date.

The payout at maturity will be par unless either ETF closes below its knock-in level during the life of the notes, in which case the payout will be par plus the return of the lesser-performing ETF, subject to a maximum payout of par.

The main risk associated with the structure was the type of barrier used at maturity. If one of the funds drops more than 40%, investors’ principal will be at risk even for a less than 40% decline at maturity because the knock-in event annihilates the protection. What makes the product considerably riskier than most worst-of, sources said, is the fact that the knock-in can occur on any trading day. This type of option is known as “American” as opposed to the regular “European” barrier observed at maturity only or “point to point.”

American barrier

“We typically don’t do American barriers. It’s too risky. Clients don’t like them,” a market participant said.

“Of course, the American barrier here is what gives you the high coupon. You would not get 12.75% in yield with a European barrier.

“But you should do this deal with a European barrier given the existing risks. For one, you’re dealing with two sectors, not two broad-based indices, and second you have the worst-of. This is a double risk.”

For this market participant, the wide size of the contingent protection was not sufficient to make the structure enticing.

“Most deals have a 70% barrier. But they all have European barriers.

“I would put a European barrier and raise the level to pay for it.”

Doing so however would be likely to reduce the size of the coupon.

A financial adviser after considering the barrier type and other risk factors said he would not consider the notes.

Good news

“I have no problem with Credit Suisse credit. That’s the good news,” said Steven Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management.

“The second piece of good news is the two-year term, which is something we like. We don’t do long tenors.

“Pretty much everything else is bad news. This is not a note we would touch.

“Sure, making more than 6% in six months is very nice. But what do you risk?”

Volatility

First off, the two underlying funds are volatile, he said.

The implied volatility for the Energy Select Sector SPDR fund and the SPDR S&P Biotech fund is 21% and 28%, respectively.

In the past year, the biotech fund dropped 9.5%. The energy fund is down nearly 20% during the same time.

“Your return is linked to two sectors that are among the most volatile. Energy and biotech: these are very volatile areas to own.

“Then you have the issue of the barrier. Anytime you go down more than 40%, you can lose your principal.”

A 40% decline in either one of these sectors is not impossible, he noted.

The SPDR S&P Biotech ETF incurred a severe bear market last year dropping 37% from July to December.

“If you breach that barrier at 40% you have no more protection. That’s the risk.”

Low correlation

Another important problem was the worst-of payout.

Investors are subject to the risk of the worst-performing fund. As a result, they are not just taking risk on each underlying, but also on the relationship between the ETFs, as stated in the risk section of the prospectus. A negative or low correlation between the two funds increases the odds that at least one will perform poorly, the prospectus stated.

The three-year coefficient of correlation between the two underlying ETFs is 0.5. On a one-year period it is 0.76.

“If at least those two were highly correlated, your risk would be substantially lower. But they’re not. You could have a real boom in biotech while energy has a significant decline and vice-versa.

“This is hardly an incentive to get into that type of risk. Your upside is limited to a coupon, which is not even guaranteed. And you’re fully exposed to the downside.

“Not a good risk-reward,” he said.

Plain-vanilla wanted

Foldes brought another drawback.

“There is a further issue. The level of complexity would make this deal a nightmare to explain to a client. There are too many moving parts. The two sectors, the breach of the barrier during the term of the notes, the worst-of, the autocall...

“This is just not something we would want to do.”

In conclusion, he said he wished he could see more “plain-vanilla” notes in the market rather than worst-of.

“We’re not seeing as many levered upside deals as we used to. Those can give you significant returns and they’re much easier to explain.”

Credit Suisse Securities (USA) LLC is the agent.

The notes will price on Oct. 31.

The Cusip number is 22552FY22.

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