Credit Suisse’s market-linked step-up autocalls on S&P: ‘expectations matter,’ advisers say

By Emma Trincal

New York, May 7 – Credit Suisse AG, London Branch plans to price autocallable market-linked step-up notes due May 2021 linked to the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par of $10 plus an annualized call premium of 7.5% to 8.5% if the index closes at or above the initial level on any annual observation date. The exact call premium will be set at pricing.

If the notes are not called and the index finishes above the step-up value, 125% of the initial level, the payout at maturity will be par plus the index gain.

If the index gains by up to the step-up level, the payout will be par plus the step-up return of 25%.

Investors will be exposed to any losses.

Exposure

“It’s a note I would do,” said Carl Kunhardt, Wealth adviser at Quest Capital Management, saying that the notes are likely to outperform what he expects the market performance to be over the next three years.

He first looked at the underlying exposure.

“It’s U.S. large caps. I’m going to always have it in the portfolio.”

He then compared the benefits of the notes with the index fund.

“Am I better off with this note or with the index? Well it all depends on my market expectations. I’m losing the dividends, something to keep in mind too.”

In spite of this disadvantage, his preference would go to the notes over the index.

“I don’t expect the market to do much. I see the notes easily outperforming the index,” he said.

Expectations

Kunhardt uses Mercer’s five-year predictions to make his investment decisions. For U.S. large-caps, the consulting firm anticipates a 4.3% annual return.

“I don’t have downside protection with the notes. But I don’t have it either with the index,” he said.

“I don’t have any dividend with the notes. But let’s say my return is 8%. Subtract 1.8% in dividends. That’s 6.2%. You do the math. 6.2% versus 4.3%. I’m much better off with the notes.”

It is unlikely that the notes will mature however.

“I may not get the final 25% at maturity. Chances are the notes will be called on the first year. But I’m outperforming the market,” he said.

If the notes do not get called, investors are at a risk of losing 100% of their principal.

He reiterated that this risk is similar to that of a long position in the index.

Additionally, losing money during that timeframe is unlikely, he said.

“We’re talking about the S&P. What is the probability that three years from now, the S&P would be below its initial price? It’s a pretty low probability.”

Opportunity

Another risk is if the S&P 500 index rises above the call premium when the notes are automatically called. Even if the return at maturity is uncapped, the call premium limits the return to 8% a year.

“There is a cap. And with that, the risk of missing out on the upside,” he said.

“That’s the real advantage of being long the index.

“But I’m not concerned by this because my expectation is 4.3%. It’s not 8%.

“What really matters here is your expectation. Everything revolves around what you expect the market to do.

“If you expect even an 8% return a year, this note might not look that attractive given the loss of dividend.

“But if you have a very modest outlook as I do, this is a no-brainer.”

No buffer

Michael Kalscheur, financial adviser at Castle Wealth Advisors, had more reservations about the product.

His first concern was the full exposure to the market decline.

“I’m very focused on downside protection. That’s why we put our investors in structured notes to begin with,” he said.

“Each time I see no buffer I immediately start to compare it with a direct investment in the index.

“If you don’t have the protection, you’d better have very good terms to justify it.”

In this case, Kalscheur said the call premium was low and could only match a “very mediocre” outlook.

“If I’m going to take equity risk, I want to see equity returns. Taking full downside risk to be capped at 8% is not very compelling to me,” he said.

Kalscheur said he discounted the value of the uncapped upside at maturity given the greater probability of being called during the life of the notes. This argument is why he considered the call premium as the cap.

In fact, the chances of a positive return at maturity were lower after missing two annual calls, he noted.

Back testing

He evaluated the risk-reward profile of the notes using back tested returns on the S&P 500 index for the past 30 years based on three-year rolling periods.

He found that the total return of the index finished negative 27% of the time. In this situation, the notes would perform similarly to the index.

The notes would outperform the index only 18% of the time – when the index performance would range between zero and 8% a year.

On the other hand, when the index performance exceeded the 8% premium, investors in the index would be better off than note holders. That situation happened 55% of the time.

“I’m not even taking into account the loss of dividends,” he said.

Small gains

“You really have to have a lukewarm outlook on the market. I have one chance out of four of losing money and even more than that at 27%. I’m going to take on market risk just to make 8% a year. It’s a small return and I only have an 18% probability to achieve that very small ambition.”

In addition, Kalscheur said that he is not comfortable with the autocall.

“You don’t know your duration. How do you plan for this? It’s likely to be a one-year, but you have to assume you’ll be locking up your money for three,” he said.

Leverage preferred

The chances of underperforming the market were too high, he noted, based on his back-tested analysis.

“It’s not levered. It doesn’t have downside protection. I’m not getting the dividends. The cap is too low.

“Why am I doing this?

“And I have a nearly 60% chance of underperforming the S&P.

“If I must have a cap I’d rather have leverage and a shorter term with no call.

“I can’t get excited about this note.”

BofA Merrill Lynch is the agent.

The notes will price and settle in May.

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