Credit Suisse’s contingent market-linked autocalls on ETFs offer worst-of sector exposures

By Emma Trincal

New York, Feb. 12 – Credit Suisse AG’s 0% market-linked securities due Feb. 15, 2024 – autocallable with contingent coupon and contingent downside linked to the least performing of the Financial Select Sector SPDR fund, the Consumer Staples Select Sector SPDR fund and the Energy Select Sector SPDR fund provide sector exposure to the worst of the three U.S. economic sectors, said Suzi Hampson, director of research at Future Value Consultants.

“This is not a diversified portfolio,” she said.

The notes will pay a contingent quarterly coupon at an annual rate of 6% to 7% if each ETF closes at or above its 60% coupon threshold on the observation date for that period, according to a 424B2 filing with the Securities and Exchange Commission.

The exact coupon rate will be set at pricing.

The notes will be called at par if each ETF closes at or above its initial level on any quarterly observation date after six months.

The payout at maturity will be par unless any ETF finishes below its 60% downside threshold, in which case the payout will be par plus the return of the worst performing ETF with full exposure to any losses.

Correlations

“The choice of underlying is based on sectors, not geographic regions. You wouldn’t expect them to be very correlated but actually correlations are quite high,” she said.

The correlations between the three ETFs are comprised between 85% and 90%, she noted.

“Correlations move like other things and if you have a little bit of unrest and disruption in the markets as we certainly have seen recently, correlations tend to go up,” she said.

High correlations in a worst-of are valuable to investors as they increase the chances of receiving the coupon payment and lessen the odds of losses at maturity, she said.

“It reduces the risk, and for that reason your coupon goes down,” she said.

Volatility

Another factor providing additional premium to pay for a higher coupon is the volatility. Future Value Consultants calculates the volatility based on historical data.

“Banks when they price use the implied. We make some adjustments to take that into account and give a more forward-looking picture,” she said.

“What comes out of our report is the fact that correlation between those three funds is higher than it usually is.”

The relatively high correlation makes it more difficult to price a high coupon, she noted.

In addition, the three underlying ETFs are “not very volatile,” she said.

The Energy Select Sector SPDR fund is the most volatile of the three at 35.15%. But the Financial Select Sector SPDR ETF and the Consumer Staples Select Sector SPDR fund have a volatility of 23.44% and 18.09% respectively.

“They’re not high volatility assets, and they’re quite correlated. Therefore, we’re not looking at a very high coupon,” she said.

Still the barrier was relatively defensive, which had to be financed.

“They’re using three underlying. That’s where the risk is built in. The coupon is not very exciting, but the 60% barrier is low. They could have gone for a high coupon and high barrier. Instead, they built a defensive product and to pay for that you have to lower the coupon.”

Product-specific tests

Future Value Consultants’ stress testing helps determine the risk associated with a structured note based on market types and market outcomes.

Hampson produced a report on the notes for analysis.

Each report contains different sections or tests based on five distribution assumption sets. They represent five market scenarios, which are based on volatility as well as different growth rate assumptions. Those are bull, bear, less volatile and more volatile. In addition, a neutral scenario is the basis of the simulation in all reports. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

Hampson used the product-specific tests to analyze the product, which is one of the 29 tables included in each report.

The probabilities displayed in this table include probability of barrier breach, probabilities of call at various dates, and probabilities of coupon paid by number of payments among others.

“The first call is in six months rather than in three months,” she said.

“Just because the first call happens later does not change the fact it’s always going to be the first call that has the highest probability.

First call

“Pushing further the first call point doesn’t influence the probability much. It does but the effect is small.”

With a single underlying, the difference between an immediate and a delayed first call would be more noticeable.

“You would see a higher jump in the probabilities with a single asset note,” she said.

The nature of the underlying, not the date of the first call is what really impacts the probability of the first call.

The table in the neutral scenario shows a 36% probability for a call at the first point. A single underlying usually would have a 45% to 55% probability for a call at the first point, she noted.

“Worst-of show a much lower probability. It’s 36% here in the neutral. Even in the bull scenario it’s only 42%,” she said.

“That’s how the worst-of has a big effect in raising the risk and possibly enhancing the coupon,” she said.

Dangerous ending

Since the chances of a call at the first point are much lower with a worst-of than with a single underlying, the probability of a “no call “outcome is higher, she said. Investors will see the note mature 37.13% of the time.

“That gives you a greater chance of breaching the barrier,” she said.

She explained why.

“Now you missed the last call and that’s three months before maturity. You would have to be below 100 every three months and at the end you’re still not at 100. At that point, the chances of being below 60% are relatively high,” she said.

The barrier is breached 24.13% of the time, the simulation showed.

Average loss

If the barrier is breached, investors are unlikely to lose only 40%. The average loss associated with this outcome is 53% of principal, according to the report.

“The probability of losing capital is 24% under the neutral scenario. Again, this is relatively high but pretty normal for a worst-of,” she said.

“So even though the 60% barrier looks decent and you’ve got three years, it is a worst-of, which adds much more risk,” she said.

“One of the three underlying, the energy fund, is also more volatile than the others. That’s another thing.”

She was referring to the Energy Select Sector SPDR.

“If something moves by 35% a year – and you only need one to move – the event of the barrier being breached is quite possible,” she said.

Dispersion

Investors need to understand the risk associated with a worst-of, she concluded.

“With a diversified portfolio, you want uncorrelated assets to minimize risk. With a worst-of, you’re adding risk when you choose uncorrelated assets.

“As an investor, your job is to know if the coupon is high enough to compensate you for that risk,” she said.

Wells Fargo Securities, LLC is the agent.

The notes were expected to price on Friday and will settle on Feb. 19.

The Cusip number is 22552XBS1.

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