Credit Suisse’s 2% digital barrier notes tied to S&P, Russell have good terms, but cap is low

By Emma Trincal

New York, Aug. 3 – Credit Suisse AG, London Branch’s coupon digital barrier notes due Aug. 30, 2021 linked to the S&P 500 index and the Russell 2000 index offer an unusual structure, buysiders said, which combines a digital return, a worst-of payout and the delivery of a fixed coupon.

The notes allow investors to outperform the market if the worst performer of the two indexes is negative within a range. But sources said the upside potential is too low in a bull market, which, in their view, constitutes the weakness of the product.

The coupon rate is expected to be 2% per year, payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

A knock-in event will occur if either underlying index finishes at or below its knock-in level, 70% of its initial level.

If a knock-in event does not occur, the payout at maturity will be par plus the fixed payment percentage, which is expected to be 31% to 36% and will be set at pricing.

If a knock-in event occurs, investors will lose 1% for every 1% that the lesser-performing index’s final level is less than its initial level.

Carl Kunhardt, wealth adviser with Quest Capital Management, said he likes the fixed coupon in addition to the potential digital payout.

“I would consider it,” he said.

“At issue with structured notes is the fact that you’re not getting anything along the way ... no coupon. Almost everything is point-to-point. Either you win or you lose. The second issue is that you’re not receiving the dividends.

“Here at least you’re getting a 2% return each and every year no matter what the end result is. With the 2% a year, the dividends are back in play.”

Worst of

Some investors object to worst-of payouts because it only takes one of the underlyings to breach the barrier, which can increases the risk of loss.

But the prospectus explained in its risk section that this outcome is less probable when the two underlyings are correlated because “there is less likelihood that only one underlying will cause the securities to perform poorly.”

Kunhardt said the relatively high correlation between the two benchmarks alleviates some of the uncertainty.

“Those two indexes are correlated, and we even know which one of the two is the most likely to underperform. In a down market it’s going to be the Russell 2000 because it’s the more volatile of the two,” he said.

“The fact that the payout is linked to two indexes is almost a moot point. Your return is only going to be linked to the Russell 2000. You pretty much know it. It means you’re getting exposure to small-cap U.S. equity.”

Small caps

Kunhardt said that part of his due diligence when considering a structured note is to make sure he wants to allocate to the underlying asset class.

“Do I have U.S. small caps in my portfolio? Of course I do. We might underweight small caps, but in most cases, we’re always going to have a small-cap allocation,” he said.

“The notes allow me to play this asset allocation on a long position with a 30% barrier.”

Investors who worry that six years from now the Russell 2000 might be down by more than 30% should not buy the notes, he said.

“I don’t think it could drop that much point-to-point in six years. Even if it did, I am no worse off than if I had held the index.

“In fact I am better off because once the barrier is breached, I’m not really long the index. I have my 12% in coupon, which can be used as a small buffer.

“Worst-case scenario, you’re long the position including the dividends.

“Best-case scenario, I’ve collected the equivalent of my dividends and I’m getting another 7.5% to 8% a year.”

Opportunity cost

The combination of a barrier and 12% buffer-equivalent make the notes quite attractive for a defensive play, he noted. The upside potential, however, is the less attractive aspect of the deal.

“The only negative is the cap. Yes, it’s a low cap. Eight percent a year is not huge,” he said.

But the cap is part of a trade-off.

“They’re giving you a buffer that’s not tied to anything at all and a fairly generous barrier. Nothing is free,” he added.

Any opportunity cost on the upside would remain limited because the investment in the note would only represent a small fraction of the small-cap bucket, he said.

“If small caps really take off, at least the biggest part of your allocation will do well and your structured note will be like a bond investment.

“A client is not going to complain about 8% in a structured note if it’s not 100% of the allocation. It is what it is.”

Terms

Michael Kalscheur, financial adviser at Castle Wealth Advisors, also objected to the upside cap while pointing to some of the positive aspects of the deal.

“It’s an interesting one,” he said.

“The terms are good.

“Both indexes are well-established. Every investor knows them.

“We’re comfortable with Credit Suisse. They have good CDS spreads. They’re single-A rated.

“The six-year tenor is a little bit long, even for us. But it’s OK.

“The 3.8% fee is fine. ... When spread out over six years ... we’re talking about 63 basis points a year. That’s reasonable for us. We like the fee to be less than 1% a year. That’s in the ballpark.”

Kalscheur said he soon realized that the downside risk is manageable even if he is “not a fan” of barriers.

Downside

“From a statistical point of view, it is very unlikely that the market would be down 30% in six years,” he said.

The adviser compiled data for the S&P 500 since 1950 based on daily data points. He used it to assess the odds of a 30% or more decline over a six-year period in the last 65 years.

“It’s not the Russell. It’s the S&P. But it’s close enough to give us a sense of the risk,” he said.

He found that the S&P 500 dropped by more than 30% over a six-year period only 0.4% of the time in the past 65 years.

A second reason to be more serene about the market downside is the existence of the 12% fixed return from the coupon.

“It’s like a buffer. You’re going to be ahead of the game,” he said.

The notes outperform on the downside when the market drops by less than 30%, he said.

With a 36% digital payout and the 12% cumulated coupons, investors could gain 48% in the best scenario.

Assuming the index closes near the barrier, the notes in theory could outperform by 70%, he said.

Cap

“The problem is not the downside. The problem is the upside,” he said.

Going back to his statistics, he found that the chances for the S&P to gain over 50% during a six-year period were 52% of the time over the last 65 years.

“And it could be substantially more than 50% at times,” he said.

With the notes investors may not expect to earn more than 48% regardless of the market.

“This digital coupon is a cap on your performance. I don’t like caps,” he said.

“Statistically speaking there is a very good chance – actually a 22% chance – that the market would be up 100% over the next six years.

“Why would you want to give up this opportunity?”

Kalscheur realizes the limitations of statistics in today’s market as the long bull cycle may be near its end, raising the odds of a correction.

“But it’s a six-year term deal. I’m confident that you would get the digital because I don’t believe the market will be down in six years. If I’m going to be locked in for six years, I would rather have no digital, just a one-to-one exposure with a 20% buffer and a much higher cap.

“This is also based on my view. I’m pretty optimistic.

“For some investors, the notes may be appropriate.”

Overall, Kalscheur said the note is “not a bad” one.

“It’s kind of a 50/50 bet. Am I willing to give up some of the upside to reduce my risk and to possibly outperform the market if it’s down?

“Me personally, I’ll take my chance with having more upside potential.

“For the right person though, someone who already has a large equity allocation and wants to take less return for less risk, that might work.”

Credit Suisse Securities (USA) LLC is the agent.

The notes are expected to price Aug. 21 and settle Aug. 28.

The Cusip number is 22546VJ98.

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