Credit Suisse's absolute return notes linked to S&P 500, Russell work with no big price swings

By Emma Trincal

New York, Aug. 27 - Credit Suisse AG, Nassau Branch's 0% absolute return barrier securities due Dec. 26, 2014 linked to the S&P 500 index and the Russell 2000 index are a non-directional investment designed for investors who believe the markets will remain within a specific range, sources said.

For those who foresee a strong volatility spike during their 27-month tenor, the notes represent a significant risk, however.

The notes offer a chance to earn an absolute return payout, or generate a gain out of a negative market. But this option is only available if neither of the two indexes declines by 40% or more during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission, which defines the occurrence of such a decline as a knock-in.

If the final level of the lower-performing index is greater than or equal to its initial level, the payout at maturity will be par plus the return of the lower-performing index, subject to a maximum return of 27.5% to 32.5% that will be set at pricing. This cap is the equivalent of about 12.25% to 14.5% per year.

If the final level of the lower-performing index is less than its initial level and a knock-in event has not occurred, the payout will be par plus the absolute value of the lower-performing index's return.

If the final level of the lower-performing index is less than its initial level and a knock-in event has occurred, investors will be fully exposed to the decline of the lower-performing index.

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he likes the notes because he sees U.S. stock prices trading in a contained range over the next two years and three months.

Sideways play

"This note totally depends on what your outlook on the economy is. I like it because I see the market trading range bound," he said.

To him, the 40% contingent buffer is sufficient.

"We're still talking about generic U.S. stocks, the plain old large-cap companies and small companies, nothing exotic, which short of 2008, are not going to hit the 40% trigger. They're giving me enough of this downside protection to feel OK about it," he said.

While Kunhardt said he doesn't like to be capped on the upside, his mildly bullish view allows him to tolerate the level offered by the issuer.

"If you're going to get the lower of the two [Russell 2000 and S&P 500] and they are both up, you can ignore the small cap altogether. The lower is more likely to be the S&P, and if my cap is 14% on the S&P, I'll take that all day because I don't expect the benchmark to go up that much anyway," he said.

Investors in the notes should be more concerned about the magnitude of price moves rather than their direction, he said.

"If you're strongly bullish, I don't know why you would bother. I am not strongly bullish. I don't think we'll see large returns, but I think we'll see positive returns," he said.

Absolute return

On the downside and in the absence of a knock-in event, investors, in theory, could make up to 39.99% in gains from the absolute return feature, although the closer one gets to the knock-in level, the greater the chances of triggering the event.

"On the downside, there is a possibility that we could go back to a mild recession," said Kunhardt.

"Again, if you're very bearish, you don't have any reason to buy this note.

"But I'm not very bearish. I don't think we're going to clip into 40. If we do, it's just like being long the market, and I would have a very small piece of my portfolio in it anyway."

The attractive aspect of the notes is that they can offer a positive return regardless of the direction of the market. Investors with a moderate view - bulls or bears - could benefit from it, he said.

"If you're only mildly bearish, you can make the argument that two years from now the market could end up being 10%, 15% or even 20% down. What that knock-out does is give me a 25% gain if the market is down 25%. It's not a bad place to be," he said.

"I like the flexibility. If you're mildly bullish or mildly bearish, it works for you.

"If you're in a no-man's land kind of limbo market, in that middle ground, it's not a bad note.

"That's what we used to build with straddles all the time. With this note, you're just doing it in a much more cost-efficient way."

That is not to say the product is suitable for everyone, he noted.

"For the majority of my clients, it wouldn't work. It's too complex," he said.

"But I like the strategy for my younger aggressive clients, the ones that are on my two more aggressive portfolios."

The option equivalent of this strategy is called a short straddle. It consists of the simultaneous writing of a call and a put with the same expiration date and at the same strike. In this particular case, the upside and downside strikes are not exactly the same - at 32.5% and 40%, respectively. But they are close enough to mimic the option strategy.

This options strategy can become significantly risky when volatility rises, which is a big concern for some advisers.

Scott Cramer, president of Cramer & Rauchegger, Inc., said he is one of them because he stays away from structured notes in which 100% of principal can be lost, as it is the case with this one.

Unforeseen events

"Because of these low interest rate spreads and low volatility, the people who create these products have to be innovative in their designs," he said.

"But I'm not thrilled about these notes. The reason you do structured products to begin with is because you want principal protection. With this one, you're not guarded against a catastrophe, and if the catastrophe happens, you get to participate in it.

"The only real gain is if one index ends up negative without falling by 40%."

This is the equivalent of a play on volatility for the next 27 months.

"You have to believe the markets will be volatile but not volatile enough to get knocked out," he said.

"If we have one of those major events hanging out there, some sort of terrorist attack, some sort of war, then you can potentially get knocked out and participate to the losses at 100%."

Full downside exposure

"I strongly believe that structured products are made for principal protection or at least that you should have a giant buffer to mitigate the downside risk," Cramer said.

He said that returns depend on the range of price fluctuations one is to expect.

"The person who likes this has to be mildly bearish," he said.

But someone too neutral may not benefit from the payout, he added.

"If you think the market is trading sideways, you'd be better off playing the actual index. It doesn't make sense to have your money tied up for 27 months to make a 3% gain out of a 3% market decline and not being able to sell if we have some event that will trigger the knock-out," he said.

"It doesn't lend itself to be a managed account replacement. I think the risk/reward is not here."

The notes (Cusip: 22546TYA3) are expected to price Sept. 20 and settle Sept. 25.

Credit Suisse Securities (USA) LLC is the agent.

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