Tenor, barrier make Credit Suisse’s absolute return barrier notes tied to the Dow attractive

By Emma Trincal

New York, Dec. 1 – Credit Suisse AG’s 0% absolute return barrier securities due Dec. 29, 2020 linked to the Dow Jones industrial average offered several attractive features over a six-year term, but advisers said that the relatively long duration was an advantage in this structure as it made the notes more defensive and the risk-reward profile more appealing given the uncapped, leveraged upside.

A knock-in event occurs if the index finishes at or below the 70% knock-in level, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 127.5% to 132.5% of any gain in the index, with the exact participation rate to be set at pricing.

If the index falls but a knock-in event has not occurred, the payout will be par plus the absolute value of the return, subject to a maximum redemption amount that is expected to be $1,299.99 per $1,000 principal amount.

Otherwise, investors will be fully exposed to any losses.

Good structure

“The structure is plain vanilla, I like that,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“The leverage is fine since I don’t get any cap. As long as I’m not capped, I don’t mind leverage.

“Your principal is not fully protected. But you’re not going to get 100% downside protection anywhere.

“Any buffer, barrier, kick-in, is always going to be more than what you would have by being long the market.”

Finally the pricing was in line with what can be seen in the market, he noted.

“The 3.8% fee is reasonable,” he said.

One of the less attractive aspects of the deal was the underlying, he said.

Narrow index

“One of my issues with the Dow is that it’s only 30 stocks, so it’s not really representative of the market. But it’s a widely followed benchmark that tends to be less volatile as you would expect probably because the stocks are all mega-cap.

“I probably wouldn’t do it because it’s a smaller index. But if I did use these types of concentrated indexes, the Dow obviously would be the benchmark of choice.”

For this particular structure with no cap, the long tenor was not an obstacle.

Tenor and barrier

“Six years is a bit long. At the same time the length offers an advantage: I can’t imagine the index being down 30% after six years,” he said.

Looking back, I can’t think of a time other than the early 1930s when the Dow has been down by that much over a six-year cycle.”

Kunhardt said he could only imagine a few scenarios in which the Dow would be down 30% in six years. But in all cases, the odds of a knock-in would be very small or the situation very extreme.

“The Dow could go down 30% on the first year and then the market would slowly recover, that’s one scenario,” he said.

“Or the market could be flat or slightly up for five years and then down 30% on the last year.

“Or it could be down during the entire six-year period, but that never happens.”

Picking the second scenario as an example, he said: “The market is up moderately for the first five years, let’s say 5% a year, that’s a compounded return of 27%. Then on the sixth year, you have another 2008. It crashes down 40%. Well, you’re still not going to see a point-to-point decline of 30%.

“You’d have to see the Dow down 70% to hit that 30% barrier.”

Another obvious appeal of the notes was the absolute return feature, allowing investors to generate a profit from any index decline by up to 30%.

“It makes the notes even more attractive. Even if the index is down you’re going to gain something. Since I don’t see the index down by more than 30%, it’s a win-win,” he said.

“The only thing that blocks me from buying this type of product is my bias against narrow indexes. But I admit that “I am not always consistent since I can buy separate accounts, which are run by a portfolio manager overseeing a small number of stocks, between 30 to 35 stocks.

“The Dow Jones has plenty of history. There is not a lot of surprise in that index,” he said.

“And also it’s not smoke and mirrors. I often complain about complexity. This deal has the advantage of simplicity. I like it.”

Creditworthiness

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that he would pay special attention to credit exposure, for all notes but especially for a longer-dated one as this one.

“I like the credit. Credit Suisse is rated single-A by Standard & Poor’s. Their CDS spreads are relatively tight compared to many firms,” he said.

“You have the Dow Jones as the underlying: everybody knows it; it’s predictable.

“You could argue that the S&P might be better because you get better market power meters with 500 names. But in terms of name recognition and clients’ comfort level, the Dow Jones is just fine.

“Finally, the structure passes the simplicity test. I can explain it to a client. They will understand it.”

The terms of the product were fairly attractive as well, he added.

“What you typically look for in a structure you have here: You’ve got the leverage on the upside. You’ve got the uncapped on the upside. You also have the absolute return portion over a six-year time period,” he said.

“The 30% on the downside is only a barrier, but the amount of protection seems reasonable enough over a six-year horizon.”

For Kalscheur, the longer investment period reduced the probabilities of a knock-in event, especially for a barrier observed at maturity and not during the life of the notes.

Low probabilities

“It may be possible for the Dow to be down after six years, but it’s not very probable,” he said.

“I have ancillary data that makes me comfortable about that protection level.”

He cited a study from Morningstar tracking the Dow Jones industrial performance since 1926.

“In its worst five-year period of decline, the Dow Jones was down 17%, according to Morningstar. “Obviously the longer the time – and this is five-year, not six – the less likely it is to happen,” he said.

“You can’t get any return without taking some risk. I think it’s a reasonable risk to assume that the Dow won’t be down by more than 30% in six years. To get that type of market decline you would have to see not just a recession, but a depression similar to the Great Depression.”

While Kalscheur said that he typically chooses buffers over barriers, adding that he would probably “take a 10% buffer in exchange for this barrier,” he noted that the 70% barrier offered in the notes was still “reasonable.”

Two out of three

When selecting a deal, Kalscheur said that he always wants to see “two chances out of three to win in a trade.”

He stated the following three outcomes.

“One, the market goes way up. I win. I get the uncapped and leveraged upside,” he said.

“Two, the market is average. It could be slightly up or slightly down. I win too because I’m getting the leverage on the upside and the absolute return on the downside.

“The third situation is the not-so-good scenario. If the market is really, really bad, then you’re down but you’re down as much as the market is.

“So I win in two out of three scenarios.

“Of course, there is risk. Since it’s impossible to know what the market will be like six years from now, you have to take some kind of risk. But it’s an acceptable risk, in my view.

“Some may argue that it’s not prudent to tie your money for six years.

“But for somebody who does not need the liquidity, someone who would just be making a small allocation, you can find worse places to park your money than a product like this.”

Finally, Kalscheur said the deal was well-priced.

“The 3.8% fee over six years is extremely competitive. That’s 63 basis points per year. It’s pretty good,” he said.

The exact terms will be set at pricing.

The notes (Cusip: 22547QYD2) are expected to price Dec. 19 and settle Dec. 29.

Credit Suisse Securities (USA) LLC is the agent.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.