Credit Suisse’s dual directional notes linked to S&P 500 have overly narrow range for alpha

By Emma Trincal

New York, Aug. 21 – Credit Suisse AG’s 0% dual directional buffered return enhanced notes due Sept. 10, 2015 linked to the S&P 500 index, despite having an attractive absolute return feature and a short duration, limit the odds of outperforming on the downside with an excessively thin contingent buffer, buysiders said.

If the index return is positive, the payout at maturity will be par plus the gain, subject to a maximum return of at least 9.6%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls by up to 9.6%, the payment at maturity will be par plus the absolute value of the return.

Investors will be fully exposed to the index decline from the initial level if it falls by more than 9.6%.

Too narrow

Steve Doucette, financial adviser at Proctor Financial, noted that it’s only on the downside that the structure offers return enhancement. But such benefit, delivered through the absolute return component, is only available if the index decline does not exceed 9.6%.

“You only outperform the market between zero and minus 9.6%. It’s a tough call to predict where the market is going to be in one year,” Doucette said.

Another disadvantage is that the contingent buffer amount is also very limited, he noted. Once the index falls by more than the buffer amount, investors are exposed to the full index depreciation from the initial level, according to the prospectus.

“That doesn’t make for a great risk-reward,” he said.

“If we have a 20% pullback and you’re capped on the upside, you have the total downside risk but limited upside potential.”

Risk-reward

The absence of leverage is something investors should consider carefully.

“You have zero leverage, you have a cap, and you have 100% downside exposure. You’re only going to outperform the index if it closes somewhere between zero and minus 9.6%. If you happen to stay within that absolute return range, your outperformance may be significant or insignificant depending on how much the index declines. If it’s down 1%, the outperformance is not huge. Meanwhile, you’ve put your entire investment at risk,” he said.

While shorter-dated notes tend to be favored by advisers, with this structure, the one-year maturity is not necessarily beneficial to the investor.

“The absolute return component is nice if you’re certain that the market is going to decline a little bit. But it’s a hard prediction to make on a one-year framework. A year from now we could be down more than 10% and up more than 10%. You could get a pullback and then the market could go back up,” he said.

Duration

Other recently announced deals using a dual directional payout offer longer durations. The idea is to give investors other advantages such as leverage, uncapped upside and a much lower barrier that increases the odds of tapping into the absolute return payout, he said.

An example is Barclays Bank plc’s 0% dual directional notes due Aug. 31, 2020 linked to the Euro Stoxx 50 index. This deal offers between 1.35 and 1.40 times leverage with no cap on the upside. On the downside, the absolute return feature applies to the first 40% of index decline. After that, investors are fully exposed to the downside.

“This one is not ideal either. You go too far out, and on a six-year, chances are you’re not going to need the protection anyway,” he said.

Doucette said that a balance should be found between maturities that are overly short and too long.

“When you look at these notes, what you want is not to look at next year or the next six years. You just want the next few years,” he said.

“There’s a greater likelihood to see a pullback next year than there is in the next few years.

“For the longer-dated one, the odds of being down six years from now are very slim, so you wonder if it makes sense to get the protection component. If you go six years, you go through an entire market cycle and you’re likely to have gone through a bear market and be on the way back up again.

“It’s a much harder call to make on a one-year. So in a way, even though a short-term note appears attractive, this one does not give you enough of a range to beat the market on the downside. The upside offers no return enhancement whatsoever: you can either be long the market or underperform if you hit your cap.”

Strange put

Larry Swedroe, director of research at the BAM Alliance, a community of 140 independent wealth management firms, said the product is not attractive because it is easily replicable at a cheaper cost and it leaves investors with limited chances to beat the index.

“You can replicate that type of structure much cheaper on your own,” he said.

“First off, without even mentioning the fees, you lose the dividend, which is 1.8% for the S&P. There’s a cost applied immediately.

“Second, the structure is fairly simple. You could do it on your own.”

The cap on the upside has a strike of 9.6% minus the lost dividends of 1.8%, or 7.8%.

Investors, he explained, sell to the issuer a call at 7.8% on the index since they are only being exposed to the price appreciation. Above the 7.8% strike, the issuer has the right to call the index “away from” investors. Beyond the call strike, investors no longer participate in the upside.

Simultaneously, investors sell a put to the issuer. It gives the issuer the right to “put the index to the investor” if the price falls below 9.6%, he explained. If the price goes down below the 9.6% strike, investors lose money.

“This is a strange put. It works very differently than usual,” he said.

“With a traditional put, you either have a put at minus 9% and you take all the losses beyond minus 9% or you have a put at the money and you take all the losses from zero.

“Here, between zero and minus 9%, you have a put to them at the starting price. They have a put to you at par if it strikes at minus 9%. Once the price crosses the knock-out point, your protection disappears.”

Limited protection

Swedroe said that the strike is too close to the initial level to give investors enough room for gains on the downside.

“Look, it’s like buying insurance with a small deductible. But instead of you paying for the deductible, they will pay for that and beyond that, it’s your loss. You’re on your own,” he said.

“When investors buy insurance, they don’t want protection against small losses. That’s not what they need.”

Because the structure caps the upside and limits the downside gains to a small range, investors may miss market opportunities that have been observed historically, he said.

Returns in the tails

“Stock returns are not normally distributed. They have big fat tails. Very few returns are in the range close to the means. Far more of the returns are in the tails. You’ll have a much greater percentage of big years that are up 20%, up 30%, and you’re giving that up because of the cap,” he said.

“On the downside, you’re only benefiting from a small range from zero to 9.6%.

“And then there is the duration factor. On a short period of time, you are far less likely to be in that range. The longer the term, the lower the odds of a loss. Over the long run, you have the equity risk premium built in and the inflation is on your side. It means that on a longer duration, the odds of experiencing a nominal loss are lower.”

To illustrate that price moves can be significant over time, he looked at historical returns of the S&P 500 index since 1950. During that 64-year period, there were only seven years in which the index was down by less than 9.6%, he said.

“That’s not much,” he said.

On the upside, the benchmark exceeded the 9.6% cap 39 years out of 64 years, or 61% of the time, he noted.

“For any of those years you would have given up some of the upside,” he said.

“I could go on more like that. During that period of time, you had 24 years when the market was up by more than 20% and 11 years with returns in excess of 30%.

“The big up years are much bigger than the down years.

“Here you are capped on the upside while the odds of making money on the downside are slim. It’s not likely to be a good deal.”

J.P. Morgan Securities Inc. and JPMorgan Chase Bank, NA are the placement agents.

The notes were expected to price Friday and settle Wednesday.

The Cusip number is 22547QRW8.

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