Russell 2000 notes are 'obvious' pick for small caps, analyst says, but format choices abound

By Emma Trincal

New York, Oct. 9 - Notes linked to the Russell 2000 index are "the obvious choice" for investors looking to make asset allocations to small-cap stocks, said Tim Mortimer, structured products analyst at Future Value Consultants, especially if they believe that this asset class offers more upside potential.

But choosing the right structured product may not be easy given the abundance of offerings and the diversity of structures.

Mortimer looked at three different notes linked to the small-cap index, all offering enhanced return. Two out of the three had a buffer, the other did not.

The buffered notes were announced by JPMorgan Chase & Co. and Credit Suisse in FWP filings with the Securities and Exchange Commission.

JP Morgan plans to price 0% buffered return enhanced notes due Feb. 1, 2011 linked to the Russell 2000 index.

The payout at maturity will be par plus triple any index gain, subject to a maximum return of 17% to 20% that will be set at pricing.

Credit Suisse, Nassau branch plans to price 0% Buffered Accelerated Return Equity Securities due May 5, 2011 linked to the same index.

The participation rate is lower with a payout at maturity of par plus 200% of any gain on the index. But compared to the JP Morgan deal, the Credit Suisse offering has a higher cap, which will be set between 21% and 23% at pricing.

'Pretty similar'

"These two are pretty similar," said Mortimer, pointing to Future Value's overall rating of the structures at 6.05 for the JP Morgan deal and 5.91 for Credit Suisse' offering.

The overall rating, on a scale of zero to 10, is Future Value's opinion on the quality of a deal, taking into account costs, structure and risk-return profile.

Taking the higher end of the cap range, Mortimer assumed that the JP Morgan notes would be capped at 20% and the Credit Suisse product at 23%.

"For the first one, you need the index to gain under 7% to get the full return, given the 300% participation rate. With the Credit Suisse deal, you need the index to go up more to 11.5% to make the full return. But those two are fairly similar: the Credit Suisse deal requires a better market performance but the maximum return is very high and it's the opposite with the JP Morgan transaction," said Mortimer.

The comparison between the two structures is facilitated by the fact that on the downside both offer exactly the same level of protection. Investors will receive par if the index declines by 10% or less and will be exposed to any decline beyond 10%.

"Both notes have a 10% buffer. They are identical on the downside," said Mortimer.

As a result, they have a similar riskmap of 7.49 and 7.50 respectively for the JP Morgan and Credit Suisse deals, he noted. This rating from Future Value measures the risk associated with a product on a scale from zero to 10.

One slight difference between the two deals, said Mortimer, is their maturity. The Credit Suisse notes have a 1.5-year term versus 1.25 years for the JP Morgan notes. "Overall, though, our ratings show that both are pretty much the same," Mortimer said.

Paying for a higher cap

The third transaction has no buffer but can compare with the JP Morgan notes in that it has an identical maturity and the same 300% participation rate.

HSBC USA Inc. plans to price 0% accelerated market participation securities due Jan. 28, 2011 linked to the Russell 2000 index. The payout at maturity will be par plus triple any index gain, subject to a maximum return that is expected to be 24% to 29% and will be set at pricing, according to an FWP filing with the SEC.

Investors will be fully exposed to any index decline given the absence of a buffer.

"Here your maximum return is 29% but you have no buffer. Compared with the JP Morgan deal, you will do better as long as the index does not decline by 10%," said Mortimer.

He noted that this represented some amount of risk.

"In today's market, you can go up or down 10% in a day or a week. That's the price you pay for an extended cap. You [gain] a 9% extra cap at the cost of 10% on the downside. That sounds fair."

Such comparisons on the downside and the upside are reflected in the ratings, Mortimer said. For instance, it makes sense that both the JP Morgan and the HSBC deals have the same overall rating of 6.05 and 6.02 respectively. "One gives you more return but you take on more risk."

It also made sense that the HSBC deal carried the highest riskmap of the three - at 7.72 - since there is no buffer, Mortimer said.

Looking at credit

When it is difficult for investors to decide between similar structures, Mortimer recommended taking into account the credit risk of the issuer. But in this case "those three issuers are all high in the credit spectrum," Mortimer said.

The JP Morgan notes are expected to price on Oct. 27 and settle on Oct. 30. J.P. Morgan Securities Inc. is the agent.

Credit Suisse will price its notes on Oct. 30 for settlement on Nov. 4. Credit Suisse (USA) LLC will be the underwriter.

The HSBC notes will price Oct. 23 and settle Oct. 28. HSBC Securities (USA) Inc. is the agent

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