Credit Suisse’s worst-of notes on S&P 500, Euro Stoxx offer unlimited upside, minimum return

By Emma Trincal

New York, June 26 – Credit Suisse AG’s autocallable securities due July 5, 2016 linked to the S&P 500 index and the Euro Stoxx 50 index offer a slightly different payout than most worst-of notes, one that has the potential for upside and attractive downside protection, sources said.

The pairing of the two large-cap benchmarks – the domestic index and the euro zone benchmark – is an aspect of the deal that investors should pay attention to, advisers said. Worst-of notes give investors exposure to the worst performing index of the two. As a result, studying the correlation between the two indexes, in addition to having a view on their respective performances, should be a priority, they noted.

Autocallable threshold

The worst-of deal offers an autocallable feature.

The notes will be automatically called at par plus a redemption premium that is expected to be 12% if each underlying index closes at or above its trigger level on the July 3, 2015 review date. The trigger level is expected to be 105% of the initial level, according to a 424B2 filing with the Securities and Exchange Commission.

If the notes are not called and the return of the lower-performing index is positive or zero, the payout at maturity will be par plus the greater of the lower-performing index’s return and the fixed payment percentage, which is expected to be 9%.

If the lower-performing index finishes below its initial level but above its 75% knock-in level, the return will be zero. Otherwise, the return on the notes will equal the return of the lower-performing index.

The exact terms will be set at pricing.

“I like the worst-of feature. It allows you to expand the boundaries of the deal,” said Steve Doucette, financial adviser at Proctor Financial.

“Getting a 25% contingent protection on two years is not bad. And getting all the upside or a minimum of 9% is not bad either.

“How much more risk are you really taking compared to investing on one index only? If the market is ugly, both the S&P and the Euro Stoxx will go down anyway.”

Compared to most autocallable worst-of notes, this deal, he said, offers two particularities: the 105% threshold for the autocall and the 9% minimum return at maturity.

Potential to outperform

“The 105 instead of the usual 100 level for the call makes the notes slightly different, and perhaps that’s a way for the issuer to improve the terms,” he said.

“If you get called, you’re getting 12%. Nobody is going to complain about that.

“The terms are not bad. They can do that with a worst-of. You’re playing on correlation.

“Both indexes have been going pretty closely, but the S&P 500 performance has been significantly better. There has got to be some level of non-correlation, otherwise they wouldn’t be able to pay you a 12% premium.

“If you stick in there for two years, you get either 9% or the performance of the worst index and no cap and you might outperform. Plus you get a decent barrier of 25% that covers most of a bear market pullback. I’m all for that, especially on a two-year.”

The 12% premium and the 9% minimum return are fixed, but Doucette noted that those payouts are equity-based.

“People may look at the 12% as a way to collect a coupon. I see it as an equity component. It’s an equity-based return. The only way you could get that 12% would be with high yields, but those are risky too. Same thing with the 9% return. It’s not a coupon,” he said.

“Those worst-of are complex in nature. I think they blur the lines between equity and income in some ways.”

Although financial advisers tend to shy away from complex products, Doucette said he may make an exception for worst-of notes because the benefits of those structures are visible.

“This deal has a lot of moving pieces. It gives you a lot of opportunities to outperform. You can get the 12% premium on the call or the 9% minimum return if there is no call, or you could be long the worst index on the upside with no cap or on the downside, but you have 25% to protect you first,” he said.

“It’s complex to explain, but it offers a lot of possibilities.”

Correlation

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he likes the structure as well, in particular, the fact that investors may get unlimited upside exposure at maturity.

“The structure looks relatively attractive from the perspective of the minimum return on the upside and the no cap. The barrier is good for both asset classes,” he said.

Doucette said the correlation between the two underlying indexes is not clearly established.

When two assets have little or no correlation, investors should expect better terms because the risk they are taking is greater, he explained.

In the case of the notes, the correlation coefficient between the S&P 500 index and the Euro Stoxx 50 is 0.84, with 1 being perfect correlation.

“For the most part, any large-cap index is going to be pretty correlated to the S&P, but it’s not like all large caps are correlated,” he said.

“The fact that the S&P is outperforming the Euro Stoxx and has been for a while shows that the two are not as tightly correlated as it would seem, which is why they can offer relatively attractive terms here.”

Two buckets

Yet pairing the S&P 500 with the Euro Stoxx 50 may not necessarily represent the best choice, those advisers said.

“As an asset allocator, my problems here would be how to allocate the notes, which is not totally U.S. equity and not totally international equity,” Doucette said.

“If I had to think about it in a different way, I would not use the S&P. I would use the Euro Stoxx and pair it with one of those international indexes, like the EAFA, emerging markets or the Nikkei.”

The MSCI EAFE index tracks the equity performance of developed markets outside of the United States and Canada.

“What you’re doing here is putting U.S. exposure and international exposure into one note,” he said.

“When we do asset allocation, we try to use one note or instrument per asset class. Due to the mixed exposure we have in this note – U.S. and international – I may have to do two different notes.

“I might find indexes that are less correlated between two different international indexes, which might give me better terms.”

Doucette said he likes the structure but is less comfortable with the choice of the underliers.

“The S&P has outperformed the Euro Stoxx, and as a result, the Euro Stoxx is potentially a better opportunity,” he said.

“I would prefer to go with a note that would offer more of an international bias.

“From a perspective of allocations, I’d rather go for either the international index or the U.S. but not a mix of the two.”

Valuation gaps

For Medeiros, performance and valuations are the key issues.

“My only concern is that both indexes have had a very nice run up,” he said.

The Euro Stoxx 50 index was up nearly 26% last year while the S&P 500 index gained 32%.

“From a valuation standpoint, an argument could be made for a pullback. To what degree? I don’t know. And which one of the two indexes would be the worst? I don’t know either. But I would expect a 5% to 10% pullback. I don’t anticipate a 25% correction during that time period,” he said.

Medeiros said he is bullish on both indexes.

“I could make the case for both. On the S&P side, it’s hard to make a pure valuation guess. Right now, U.S. stocks are trading at where they were in 1996. And the S&P continued to rally for the next four years. So valuation is not everything. You have to dig deeper to do a better job at managing risk. There are still signs that the bull market in the U.S may not be over. The Fed continues to have a very accommodative policy. Sentiment is still upbeat. As an example, we’re just coming off one of the worst quarters in a very long time, and the market rallied,” he said.

The GDP dropped 2.9% on an annual basis during the first quarter, according to a report released on Wednesday.

“In Europe, the market has some individual countries that have begun to show some positive characteristics,” he said.

“If you’re bullish and not too concerned about valuations, this is a pretty interesting note.”

The notes (Cusip: 22547QPR1) were expected to price Thursday and settle July 3.

Credit Suisse Securities (USA) LLC is the agent.

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