Credit Suisse's autocallable step-ups tied to S&P seen as risky play with interesting structure

By Emma Trincal

New York, April 28 - Credit Suisse AG's 0% autocallable market-linked step-up notes due May 2017 linked to the S&P 500 index offer a hybrid structure combining the capped payout of a traditional autocallable with a potential step-up payment at maturity if a call has not occurred.

Separately, investors may participate in the upside without a cap if neither the call nor the step-up payment is triggered.

But the complexity, the "narrow" market view required to outperform the benchmark and the risks associated with the product both on the upside and the downside are disappointing, buysiders said.

The notes will be automatically called if the index closes at or above the initial index level on either of two observation dates. The call premium will be 7% if the notes are called on a call date a year after issuance and 14% on the second call date after two years, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not called and the final index level is greater than the step-up value, the payout at maturity will be par plus the index return. The step-up value is expected to be 120% to 126% of the initial index level and will be set at pricing.

If the final index level is greater than or equal to the initial level but less than or equal to the step-up value, the payout will be par plus the step-up payment, which is expected to be 20% to 26%.

If the final index level is less than the initial index level, investors will have one-to-one exposure to the decline.

BofA Merrill Lynch is the agent.

Seven minutes

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he would not buy the notes because of their complexity and also because the likelihood of a call is too great, which would cap the investment at the call premium and make the other payout options moot.

"I'm not likely to use it. It would take seven minutes to explain this to a client. Usually after about three minutes, the client glazes. It's too complex. If it's too complex, I just don't have the conversation," he said.

Part of the difficulty in explaining the structure, he said, is the multiplicity of the various different outcomes regarding the payout.

"There are too many gates to go through. You travel along and you hit too many forks in the road," he said.

"First, after year one, have I been called? If yes, the index is flat or positive and I get 7%. If no, the note continues. If I get called, the first question is, what if the market is up 30% and I only get 7%? Now you're having that discussion. And wait a minute: there is no downside protection. You have the risk.

"So scenario one, you get called at 7%. Scenario two, you get called a year after at 14%. Scenario three: you have not been called, which means that the market has been down all the time. Then chances are you are not going to end up in positive territory. The market is likely to be down, and you don't have any protection.

"So either you end up with a cap or, if the market has been down for three years, chances are it's a loss given the lack of any protection. You're fully exposed to the market with no benefit for the noteholders."

Capturing a flat return

The positive outcome for investors is limited to a flat market environment, he said.

"The only way this note works is if the market is up more than zero and less than 7%. And if I want to be called on the second year, which is the best-case scenario, I have to pray that the market is negative after one year and then goes up on year two but not by a lot. You have to have a constricted market outlook in order to make this note work," he said.

"If I truly believe we'll have a flat market, a good part of me thinks there is a good chance to have a material correction. If that's the case, why would I buy this note to capture a flat return while I could be getting a short-term bond and waiting it out?"

The notes are designed to be "a proxy" for equity, not a proxy for fixed income, he said.

"But then, what is the point of holding an equity-like investment with no protection at a rate of return of 7% a year hoping for the best-case scenario, which is a flat market?" he said.

No value

According to Kunhardt, the notes would not add value to the portfolio.

"In order to invest in something, you have to have a reasonable expectation of return. In order for me to include something in the portfolio, I have to see value," he said.

"I'm not getting any hedging. I'm not getting any enhanced growth, two principal reasons to allocate to an alternative investment, which is how I view structured notes. I may or may not get a different correlation from the asset class because this is very much tied to equities.

"In addition to that, I am not getting protection. This would not be a deal-breaker, and I would actually consider buying a note with no downside protection, but I would have to see some value in the product. In this case, I don't."

Steven Foldes, president of Foldes Financial Management LLC, did not express a positive view on the notes either. His main concerns are the upside risk, the absence of protection and the narrow window within which investors may win their bet.

Upside risk

If the market continues to be bullish, the notes will be poorly received by investors, Foldes noted. Such scenario represents the upside risk.

"It's an interesting structure, but I would not invest in it," he said.

"Let's assume you bought this early last year. At the end of 2013, the notes would be called away, Credit Suisse would pay 7%, and the client would not have the benefit of the 32% market return."

Foldes, who tries to select uncapped products in general, said that investors should not be subject to the risk of underperforming the market.

"We want to make sure that we don't hurt our clients by virtue of the potential upside," he said.

"If you have a low cap and assuming the asset class takes off, you hurt your client compared to a long-only position.

"Let's assume you have a big year or a big second year - you're capped out while the index is higher.

"The structure is interesting because it can provide a 7% annualized premium, a not inconsequential amount of money. Historically, though, the average market return is 10% a year. You have to be careful of course because there is no such thing as a norm when it comes to historical returns. But if the index grows at those levels or more, you're doing a disservice to the client."

Easy to be wrong

Another issue with the structure, he said, is that clients have a "very narrow margin to be right."

Investors in the notes would have to be bullish since there is no downside protection.

"But they can only be very, very modestly bullish," he said.

"This bet is almost the reverse of a win-win. If the index is negative, you don't have downside protection; therefore, you lose. If the market is good, you underperform."

An investor would have to bet that the market will move sideways within a "narrow" trading range and "be right," he added.

"In order to benefit from the notes, your view would have to be very flattish," he said.

No downside protection

Finally, the absence of any barrier or buffer on the downside is a problem as well, in his view.

"If there was a significant downside protection, it would change the dynamic. But there is no downside protection at all. So let's see what you have in terms of risk. If the market is down, you lose because there is no downside protection. If the asset class appreciates beyond the cap, you lose because the client gets a much lower return. To me, it's a lose-lose," he said.

The notes are expected to price and settle in May.

The fee is 2%.

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