Three ‘odd,’ small worst-of deals linked to S&P 500, Russell 2000 puzzle sellsiders

By Emma Trincal

New York, Oct. 16 – Credit Suisse AG, London Branch, Morgan Stanley and Citigroup Inc. priced three separate worst-of deals sharing similar characteristics, mainly a small size and a complex structure, according to data compiled by Prospect News and sellside sources commenting on the terms.

All three notes had a five-year maturity. They priced early last week, on Oct. 12 and Oct. 13. The return is based on the worst performing of the S&P 500 index and the Russell 2000 index.

The notes are different from typical worst-of notes in that the payout is based on a series of strikes, with formulas applying based on where the final return fits between two strikes or ranges, sources explained.

Credit Suisse’s deal

They commented on the Credit Suisse deal as an example.

Credit Suisse priced on Oct. 13 $2.66 million of 0% capped buffered variable participation notes due Sept. 29, 2020 linked to the S&P 500 and the Russell 2000.

The worst-of deal features five different strikes as percentages of the initial index levels: 130%, 115%, 105%, 90%, and 70%. Each range between two strikes determines a specific type of return.

If the final level of the lesser-performing index is greater than or equal to 130% of its initial level, the payout at maturity will be par plus 64.5%, according to a 424B2 filing with the Securities and Exchange Commission.

If the final level of the lesser-performing index is greater than or equal to 115% but less than 130% of its initial level, the payout at maturity will be 115% of par plus 330% of the amount by which the lesser-performing index’s return exceeds 15%.

If the final level of the lesser-performing index is greater than or equal to 105% but less than 115% of its initial level, the payout at maturity will be par plus the return of the lesser-performing index.

If the final level of the lesser-performing index is greater than or equal to 90% but less than 105% of its initial level, the payout will be par plus 33% of the amount by which the lesser-performing index’s final level is greater than 90% of its initial level.

If the final level of the lesser-performing index is less than its initial level by more than 10% but not more than 30%, the payout will be par.

If the final level of the lesser-performing index is less than its initial level by more than 30%, investors will lose 1% for every 1% that the lesser-performing index declines beyond 30%.

Tricky

Sellsiders noted the peculiar complexity of those layers of payout.

“I don’t know what the rationale is. It’s hard to say,” said a sellsider.

“It’s unusual ... even a little odd.”

A structurer had the same reaction.

“Quite a few tiers. It’s very weird,” he said.

Buffer

Those sources agreed that one of the main appeals of the structure is the protection.

“The 30% buffer on the downside for five year is pretty attractive. It’s a real buffer, not a knock-in, which is good. It’s safer,” said the sellsider.

The structurer agreed.

“This 30% buffer is very cool,” he said.

“The first thing is that you do have this 65% cap for five years, so that’s 13% per annum,” continued the sellsider.

“That’s your best-case scenario. That’s your target return. You’re giving up some of the upside for a strong downside protection,” he said.

Another plus, this sellsider noted, is the use of those two specific indexes.

“The correlation between the S&P and the Russell 2000 has been fairly high. It makes this note seemingly less risky just judging from the past. Of course if correlation diverges, then the risk will increase,” he said.

The structurer also pointed to correlation.

“It looks quite attractive if you’re quite bullish on the two indices or if you’re not bearish on any of the two.

“Like any other worst-of, you’re long correlation. If correlation decreases, you’re in bad shape.

“That’s the nature of worst-of. It is what it is.”

Bumpy

The structurer analyzed some of the “smoothness” between ranges and expressed surprise.

“Above 115%, it’s reasonable. You get three times, but you’re going to get capped. That 64% will be your final cap. It’s a three-times call spread above 115%. Nothing strange here.”

But the pattern changes in the lower tranche, between 90% and 115%.

“If you’re at 115% in that 90% to 115% range, you get approximately a third of what’s above 90%, so a third of 25%, which is 8.33%.

“That’s kind of weird.

“You’re at 144.99% or you’re at 115%. Big difference. If you use the lower range, the calculation gives you 108%. If you use the higher range, you get 115%.

“There is a bump. Usually it’s a smooth transition. There’s nothing right or wrong here. It’s the pricing. But it’s just very weird.

Rationale

Sources found it difficult to gauge the value of this product.

“With all of these strike levels, I don’t know why you would do this type of thing. You do have a pretty good protection, that’s for sure. But it’s a bit complex,” said the sellsider.

“From an investors’ perspective, it’s hard to describe the rationale.”

He reached similar conclusions as the structurer in terms of dispersion of returns.

“It’s too discontinuous. Too many ranges. Each range is not naturally flowing,” the sellsider said.

“In some cases between 90% and 115%, the market beats the worst-of. In others, like between 115% and 130%, you will outperform. Above 115% up to the cap, you will do better with the note.

“It seems a little bit irrational. It’s like a bet. You don’t really know what you’re going to get until the final computation.

“From a pricing perspective, if you’re looking at your models, perhaps it says that it’s not likely that you will be above 115%, so let me give you a more attractive return.

“But from a client’s perspective, I’m not sure.

“It may be an institution seeking a target return and specific outcomes maybe because they’re trying to match assets and liabilities.

“Maybe it’s a trading desk or a hedge fund. Who knows?”

Fees for three

This sellsider did not find any helpful clue in the fees.

The Credit Suisse notes (Cusip: 22546VNV4) carried a 1.54% fee.

Two other very similar deals had fees of 2.5% and 1%, respectively.

Morgan Stanley priced $2 million of 0% buffered securities due Sept. 25, 2020 linked to the worst performing of the S&P 500 and the Russell 2000, according to a 424B2 filing with the SEC.

The notes (Cusip: 61765R743) priced on the same day as the Credit Suisse offering, Oct. 13.

The fee was 2.5% fee.

A day before, it was Citigroup that started the triplet of deals with $2.66 million of 0% buffer securities due Sept. 25, 2020 linked to the worst performing of the Russell 2000 and the S&P 500, according to a 424B2 filing with the SEC.

The notes (Cusip: 17298C3L0) carried a 1% fee.

Potential buyers

“It’s a little bit strange. I am puzzled. The commissions are not extremely high but fairly high for a [registered investment adviser]. An RIA would probably be closer to par,” the sellsider said.

“Somebody is buying it at a discount and selling it at par to a client, like it’s normally done.

“But it’s odd for a retail client to buy three different issuers with such an unusual structure.”

This sellsider, however, said he believes that the deals had been sold to only one party.

“The fact that it’s fairly specific tells me that it was sold just for one client who wanted issuer diversification,” said the sellsider.

“Each firm sold it by themselves. It looks like it was for just one client.

Retail of course

The structurer was more definite in guessing the potential type of clients on those deals.

“It sounds pretty retail to me,” he said.

“I don’t really see institutions buying that kind of stuff.

“Above 115% you get a lot of action, but between 90% and 115% you only get a third of it.

“It’s good because you get protection all the way down to 70%, but you also leave money on the table.

“The size is interesting. Why would an institution waste all its time with a $2 million trade?

“It may be an RIA, but not an institutional trade.”

More details

The Morgan Stanley and Citigroup deals offered almost the same structure except for their cap of 64.5% and 64.95%, respectively.

They differed from the Credit Suisse product in that the higher range, above 130%, was eliminated with the highest strike now at 115%.

Secondly, there was no longer any digital payout for the highest tranche but participation offered up to the cap.

The terms common to the Morgan Stanley and Citigroup deals were as follow:

If the final level of the worst-performing index is greater than or equal to 115% of its initial level, investors get 115% of par plus 3.33% for every 1% that the worst-performing index’s return exceeds 15%, subject to a 64.95% maximum return.

If the final level of the worst performer is greater than or equal to 105% of initial level but less than or equal to 115% of initial level, investors get par plus the return of worst-performing index.

Between 90% and 105% of the initial level, investors get par plus 0.3333% for every 1% that worst-performing index’s final level exceeds 90% of initial level.

If the final level of the lesser-performing index is greater than or equal to70% of its initial level but less than 90%, investors get par.

If the final worst-of return is less than 70% of its initial level, investors lose 1% for every 1% that the worst-performing index declines beyond 30%.

Credit Suisse Securities (USA) LLC was the underwriter for the Credit Suisse deal.

Morgan Stanley & Co., LLC was the agent for its affiliate issuer.

The underwriter for the Citigroup deal was Citigroup Global Markets Inc.

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