Credit Suisse’s $19.39 million 7% STEP Income notes on Apple offer fixed rate, digital bonus

By Emma Trincal

New York, Nov. 29 – Credit Suisse AG, London Branch’s $19.39 million 7% STEP Income Securities due Nov. 30, 2018 linked to Apple Inc. common shares allow investors to get extra income by providing a portion of the coupon on a contingency basis, sources said.

The structure type dubbed “STEP Income” by BofA Merrill Lynch is not new, although most exclusively distributed by this agent, according to data compiled by Prospect News. But “STEP Income” notes are far less common than their growth-oriented counterpart called “market-linked step-ups,” which are also mainly distributed by BofA Merrill Lynch, the data showed.

Interest will be payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

If the price of Apple shares finishes at or above the step level – 107% of the initial price – the payout at maturity will be par of $10 plus a step payment of 4.55%.

If the stock finishes at or above the initial level but below the step level, the payout at maturity will be par.

Investors will be exposed to any losses.

No downside protection

“This is interesting. It’s a reverse convertible with a one-to-one exposure to the downside. Most reverse convertible come with some kind of barrier or buffer,” said an industry source.

“At least... but that’s true to all those deals... you have a little bit of a cushion from the coupon.”

The “cushion” is 7% while the dividend yield of Apple is only 1.45%.

“It’s a short maturity and Apple doesn’t pay a rich dividend. As a noteholder, you lose the dividend but you do get the coupon. You’re always better off on the downside.

Investors in those notes are unlikely to use it to beat the stock nor as an equity replacement. Instead they monetize the volatility of the stock to get above-average income.

But if one wants to compare the payout with a long position, noteholders should be mildly rather than very bullish, he said.

“The only time you come ahead of the game is if it’s up a little bit,” he said.

Given the volatility of Apple as a technology stock, this source said he would rather have some protection on the downside in the form of a barrier or buffer.

Bonus versus barrier

“That’s how regular reverse convertibles usually look like. This one is different. But they give you a 7% guaranteed. I doubt you could get the same coupon plus the protection on that deal,” he said.

“What they did is take out the protection and give you an extra coupon based on the market.

“Maybe it was designed for someone who is not necessarily looking for extra protection but wants a higher coupon if the market is up.... Less protection but more income if the performance is good.”

Adding a digital

A market participant said the structure combined a reverse convertible and a digital option.

“Your 7% is like a coupon. And if you go above 107%, they pay you a digital, which is some kind of a bonus,” he said.

“Seven percent is very reasonable.”

If investors earn the bonus at maturity, their annual return becomes 11.45%.

“They don’t pay you the whole coupon. They use it to buy the digital. If you remove the contingency of bonus, which they call the step, your potential upside would have to be less than 11.45%. Let’s say – and I’m making that up – it would be more like 9% for instance.”

From his example, investors agree to earn only 7% in guaranteed payment in the hope of receiving the 4.5% additional return at maturity. If they took the extra 2 points for a 9% fixed rate, they would cap their upside at 9%, effectively giving up the possibility of earning 2.5% more, he explained.

“You’re just rolling the dice. You’re risking 2% to get 4.5% more...Nothing wrong with that,” he said.

It can’t compete

Investors in the notes should stick to their goal of maximizing income, not expecting market-linked growth, he noted.

The share price of Apple is up 46.35% so far this year.

“You can’t compete with the market. Of course, you’re going to be capped. This is not a leveraged note,” this market participant added.

“All reverse convertibles, all autocallables have limited upside. It’s part of the territory.

“If an investor worries about being capped at 11.5%, let him buy more Apple shares.

“The truth is: we don’t know what the market will be like in a week, a month or a year from now.

“There is no such thing as: it will go up. Obviously, this type of note depends on your view of the stock. If you’re hugely bullish, don’t bother buying this note.”

BofA Merrill Lynch is the agent.

The notes (Cusip: 22548Y306) settled on Wednesday.

The fee is 1.75%.

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