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Published on 8/19/2013 in the Prospect News Structured Products Daily.

Credit Suisse, Morgan Stanley plan notes tied to baskets of U.S., international indexes, funds

By Emma Trincal

New York, Aug. 19 - Advisers said they have seen more notes linked to weighted baskets of equity indexes recently.

"It's a growing trend," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"We're seeing more leveraged notes tied to baskets of indices. Most of them are based on very liquid indexes or ETFs. It's more straightforward, more transparent than using the ADRs.

"If it's a market that has good secondaries, good liquidity, the [exchange-traded product] lends itself to being used in a structured note."

Two issuers recently announced such deals.

Credit Suisse AG will price 0% Buffered Accelerated Return Equity Securities due Aug. 28, 2015 linked a basket of one index and one fund, according to a 424B2 filing with the Securities and Exchange Commission.

The basket consists of the S&P 500 index with a 75% weight and the iShares MSCI Emerging Markets exchange-traded fund with a 25% weight.

The payout at maturity will be par plus about 1.5 times any gain in the basket, up to a cap of about 21.05%. Investors will receive par if the basket falls by up to 10% and lose 1% for every 1% decline beyond 10%. The exact deal terms, including participation rate and cap, will be set at pricing.

Separately, Morgan Stanley said it will issue 0% trigger Performance Leveraged Upside Securities due August 2015 linked to a basket of two indexes and an ETF.

The basket consists of the Russell 2000 index with a 35% weight, the Euro Stoxx 50 index with a 35% weight and the Vanguard FTSE Emerging Markets ETF with a 30% weight.

The payout at maturity will be par plus 150% of any basket gain, subject to a maximum return of 20%. Investors will receive par if the basket finishes above the trigger level, which will be 70% to 72% of the initial level, but below the initial level, and they will be fully exposed to the decline if the basket falls to or below the trigger level.

Kunhardt said that investors are seeking notes tied to more than just one index for diversification purposes.

"You're controlling volatility through diversification. It's the same when you want to create a balanced portfolio," he said.

"You could create it by buying the stocks one by one. But you usually end up with a balanced fund. It's easier. Same thing with a note."

Correlation

Kunhardt said that the composition of the underlying basket and the nature of the downside protection were the main differences between the two products.

"With the [Morgan Stanley deal], you have a concentration of European stocks. It's a very concentrated index of 50 stocks only," he said.

"Second, your protection is a barrier. If the basket is down 32%, you're down 32%. You're really not protected against anything."

Kunhardt said that correlation between the index components was an important aspect of an investment decision.

"I like the S&P and emerging markets basket of the first deal. It's the U.S. large caps, basically the blue chips, and emerging markets. I like it because the U.S. and emerging markets are not correlated. But European stocks and U.S. stocks, especially large caps, are. What's the difference between Nestle and Hershey? There's no difference. Developed markets in general have become more correlated to the U.S.

"I also love that you're weighting more towards the U.S. market. I like the 75% U.S., 25% emerging markets mix."

Kunhardt said that the cap and the protection on the first deal were attractive.

"I'm OK with the 21% cap. You can live with that on a two-year," he said.

"You're getting a 10%, which is a real buffer. You have to pay for that protection, and that's the cap on the underlying. No surprise there."

Volatility, barrier

Kunhardt said that comparing the volatility of the underlying baskets made him feel more comfortable with the first deal.

"The basket in the second deal is much more volatile. You have the Russell 2000, and we know that U.S. small caps have a lot more volatility than U.S. large caps. On top of that, you have the Euro Stoxx. It adds an additional level of volatility," he said.

"What if we have a slight market downturn because we have a spike? This market has been more of a spiky market than anything. We go down 10%-15%, but we don't stay there.

"Say we spike down and at the same time Italy and Greece have another credit blow-up and Germany says, 'We're not going to pay more,' even though you know that they will write a check four months later. This note has been doing great for two years and all of a sudden, before you know it, you hit the trigger given the high volatility. This basket is too volatile, and I don't want the volatility."

Michael Kalscheur, financial adviser at Castle Wealth Advisors, agreed with Kunhardt regarding the nature of the protection, preferring the buffer to the barrier.

"With the Morgan Stanley deal, the protection is a cliff. It makes me a little bit nervous. A 28% barrier on the S&P for a two-year, I would feel pretty good. Now you throw in emerging markets, the Russell 2000, all of a sudden, it doesn't feel so good anymore," Kalscheur said.

"You're getting into a more volatile basket, which compounds the risk of hitting the barrier, and that would defeat the purpose of the downside protection.

"The Morgan Stanley deal is definitely more risky. No question about that."

Outside the U.S.

"A year ago, everybody wanted to do a basket of stocks with Apple in it. I was not a big fan of this. Now you're getting to multiple indices. I like that concept," Kalscheur said.

"I think that people are searching for value. In the U.S., is the value with the S&P or with the Russell 2000?

"And where is the value outside of the U.S.? That's what you see in those two deals. Both notes have a few things in common. They both mix U.S. and international stocks, and they also have similar duration, leverage and even cap."

One of the advantages of the baskets used in the two products was that they enable investors to get partial exposure to riskier asset classes, he noted.

"The U.S. has outperformed almost every international market except Japan. Most things have returned half the S&P or have produced negative returns like emerging markets," he said.

"If you want to get exposure to emerging markets, it's a good way to dip your toe into it and get some potential downside protection. If you're worried about the downside risk, it's definitely better than buying the emerging markets fund outright. You also have exposure to the U.S. markets. Such mixture will dampen down volatility.

"I like the mix."

Cost factor

Kalscheur said that he did not have a particular preference for one basket versus the other. But he did prefer the buffer to the barrier.

"It comes down to where your perspective is on those markets," he said.

"If you're nervous, you wouldn't use the barrier notes.

"If you're a bull, you wouldn't want the cap or you would want a higher cap, although that cap is not bad.

"The credit risk is fine. Morgan is a single-A minus. Credit Suisse is single-A. It's better to be single-A than single-A minus, but it's not a deal breaker.

"My real issue with the Credit Suisse deal is the fee. It can go as high as 3%. That's ridiculous. It is way too high. I've seen lower fees for five- or six-year notes."

Credit Suisse Securities (USA) LLC, an affiliate of Credit Suisse, may pay referral fees of up to 3%, according to the pricing supplement.

"The 3% fee is cooked into the pricing of the deal. It doesn't change the buffer. But here's the question: If they had offered a lower fee, could you have got a 25% cap or a 15% buffer? That's money out the door that could have been used to make the product better," he said.

"I definitely like the Credit Suisse deal over the Morgan Stanley one, but I still wouldn't do it because I can't get over the fee."

The Credit Suisse notes will price Aug. 23 and settle Aug. 28. Credit Suisse Securities (USA) is the underwriter. The Cusip number is 22547QA48.

The Morgan Stanley notes are expected to price and settle in August. The fee is 1.125%. Morgan Stanley & Co. LLC is the agent. The Cusip number is 61762P617.


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