Credit Suisse’s barrier absolute return notes tied to S&P 500 introduce ‘condor’-like payout

By Emma Trincal

New York, May 10 – Credit Suisse AG, Nassau Branch announced an “intriguing” structured note with full principal protection on a short tenor. The structure, which sources said is unusual, will provide either small money-market-like returns or participation in the index within a range including absolute returns.

The issuer plans to price 0% barrier absolute return market-linked notes due Nov. 21, 2019 linked to the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

If the index closes above the upper barrier or below the lower barrier on any day during the life of the notes the payout at maturity will be par plus 1.5%.

The upper barrier will be set at the initial level of the index plus 17% to 19%. The lower barrier will be set at the initial level of the index minus 17% to 19%. The exact barriers will be set at pricing.

Otherwise, the notes will pay par plus the absolute value of the index return.

Wings

In its hypothetical return table, the prospectus illustrated the payout structure assuming a lower barrier of minus 17% and an upper barrier of plus 17%. Both barriers are built upon “American” types of options: they can be triggered anytime during the life of the notes rather than just at maturity, which increases risk. Investors get most of their profit when the S&P 500 always trades within the range constituted by the lower and upper barriers. Such strategies in options jargon are dubbed “condors” or “butterflies” in reference to the strikes or barriers, which on a position graph take the shape of two wings.

In the “no barrier event” scenario described in the prospectus (the price is contained in the range at all times), a decline of 17% in the index will produce a 17% profit. If the price drops beyond that, the payout will fall to the less-appealing 1.5% return. As a result, downside returns have in effect a 17% cap. The same applies to the upside: any positive return up to plus 17% is the equivalent of being long the price return of the index. Beyond the 17% barrier or “wing,” the price move takes investors back to the lower 1.5% fixed return.

Narrow window

“You’re betting that you’re going to stay in that narrow window for 18 months,” said Steve Doucette, financial adviser at Proctor Financial.

“Seems unlikely but it’s an interesting note in some limited situations.

“It’s great for short-term money because short-term, 1.5% isn’t so bad. Say you want to buy a house in two years: that’s a nice place to park your money.

“Worst case scenario: you make 1.5%. Best case: 17%. Why not if you don’t need the liquidity?”

One problem with that is the taxation of the notes, which is ordinary income tax treatment due to the full principal protection, a market participant noted.

“This wouldn’t be something interesting for our clients. It doesn’t take enough risk to qualify as long-term capital gain. It may be more appropriate for non-taxable clients,” this market participant said.

Probabilities of alpha

For Doucette, the problem of this strategy was what he believed would be a low probability of higher returns.

“You make money between minus 17% and plus 17%. It’s a 34 point range. But you don’t necessarily make a lot of money.

Investors make money within a 34-point range between the two barriers, he explained. But they only outperform the index within the first 17 points of losses.

“What are the odds that you’re never going to hit the top and bottom barriers any time? And what are the odds that you’re going to finish in this very narrow range from zero to minus 17%?

“It’s a very specific window and you have this American barrier.

“It’s an easy way to make very little money. But it’s tough to really make money.”

The market participant agreed: the chances of staying “inside the wings of the condor” were limited.

“It’s kind of a weird condor,” he said.

“This American barrier ups the odds that a flash crash or a big rally will put you in the 1.5% payout level,” he said.

“You’re really betting on a range bound market for the next 18 months.

“It may have been a great assessment when volatility was low.

“But volatility is likely to be higher.”

No leverage

The notes also lacked a real return enhancement mechanism aside from the absolute return, he added.

The payout is delta one. In comparison, the so-called condor options trades will allow investors to receive a net premium. Such net is the difference between gains received from selling the options on the trade and the cost incurred for buying them.

“It’s not as good,” he said comparing the notes to the options strategy.

“It’s not as great a bet as I thought. It seems to be much more optically than realistically a good return vehicle.

“Given the current market conditions, the chances that you’ll do better than 1.5% in 18 months are OK, but they’re not great.”

Credit Suisse and UBS Financial Services, Inc. are the agents.

The notes will price on May 16 and settle on May 21.

The Cusip number is 22550WTR8.

© 2015 Prospect News.
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