Credit Suisse’s absolute return digital notes on indexes can beat the market, not time it

By Emma Trincal

New York, Sept. 1 – Credit Suisse AG, London Branch’s absolute return digital barrier securities due Oct. 5, 2020 linked to the S&P 500 index and the Russell 2000 index give investors decent probabilities to outperform the market, advisers said, but the four-year duration led to a more complex investment decision, one of them added.

The notes, which use a worst-of payout, offer a digital return on the upside and an absolute return feature on the downside above a set barrier threshold.

If each index finishes at or above the initial level, the payout at maturity will be par plus the fixed return of between 35% and 40%, with the exact percentage to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If either index falls but each index finishes above its 60% knock-in level, the payout will be par plus the absolute value of the return of the worse-performing index.

If either index falls below its 60% knock-in level, investors will be fully exposed to any losses of the worse-performing index.

Outperformer

“You’re getting a nice barrier and the absolute return can let you outperform nicely,” said Steve Doucette, financial adviser at Proctor Financial.

“If the market is down 39% you’re looking at an outperformance that’s going to be unbelievable...and on the upside, the market is up 2% you get 40%, which is 10% a year... Not bad...”

Doucette said the range of positive outcomes – from anything above minus 40% on the negative side up to 40% on the upside was wide enough to increase the probabilities of making money.

If the lowest performing index drops 40% or more at maturity, investors would lose their protection and may in theory lose their entire investment, the prospectus warned in its risk section.

“Theoretically it could go down to zero. But if it’s zero, you and I can find a new job,” he said.

Correlation

The final return will depend on the relationships between the two indexes.

If the S&P 500 and Russell 2000 show correlated performances, the chances that only one index would perform poorly are lessened, according to the prospectus.

With worst-of payouts, the greater the correlation, the lower the risk.

The S&P 500 index and the Russell 2000 have a correlation coefficient of 0.81, according to Morningstar, which reflects a high correlation, compared to one, which represents a perfect positive relationship.

“They behave pretty much the same although the Russell is small-cap and theoretically it’s more volatile,” he said.

“So if you look at the downside, you can make the reasonable assumption that you’d be tied to the Russell,” he said.

But in reality, predicting which among the two benchmarks would be the worst-performing one is impossible, he added.

“Look at what happened in 2008. It was the S&P that underperformed the Russell then, not the other way around. So you can’t really tell.”

Four years

The S&P 500 index lost 37% in 2008 while the Russell 2000 was down by about 34%.

For Doucette, the terms of the notes were compelling. But the value of the long tenor was harder to assess.

“Our position is: what’s going to happen four years out? No one can tell,” he said.

“Are you less likely to lose money after four years from a historical basis? Not really because you’re looking at the maturity date, just one single date. Are we going to be hit by a bear market two years from now? Who knows?”

Investors who expect a bear market to occur shortly would be better off with a shorter duration in order to take advantage of the absolute return feature, he said.

Those who think the bear market may be followed by a period of lackluster market growth would do well with a longer time horizon in order to benefit from the digital bump, he added.

“The worse would be to be down 2% at maturity. You’d only outperform by 4 points.

“If on the other hand the market collapses toward the end, this note has a huge value.”

Timing the bear

Remodeling the structure would depend on the investor’s directional view on the benchmarks. It may also depend on something Doucette said he prefers not to do, which is: timing the market. But in order to assess if the four-year tenor is the most appropriate duration, one may have to make certain assumptions about the timing of a widely anticipated bear market.

“And that’s impossible,” he said.

“If I’m bearish, I would shorten the term. The digital doesn’t do me any good if the market is down.

“If I’m bullish, I’d give up some of the protection and try to increase the upside.”

Running all these hypothetical scenarios can become confusing.

“In four years we could be anywhere in this cycle. This note has a good potential for good results. But we have no idea what the market will be like then,” he said.

“That’s why I would settle for a simple buffered note instead. It’s easier to a client. Here it is: a simple buffer, some leverage up to a cap. People understand that. This one has too many moving parts.”

Tradeoff

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he liked the absolute return feature.

“It’s a very interesting structure,” he said.

“Over a four-year period, it seems to me that the absolute return component of the portfolio would be very attractive.”

As with any structure limiting the upside, one of the risks is to be “capped out” in a bullish market.

“Some could argue that the actual return of the underlier could be greater than the cap,” he said. “But it’s certainly worth the tradeoff to have the absolute return component built in.

“Having a barrier that can turn a negative return into a positive one is very attractive, certainly more attractive than what a typical barrier does.”

Market cycle

The four-year tenor was not a negative in his view.

“Often when you look at what some investors do when they buy a note,” he said. “They take a relatively volatile security or something that already has a high valuation and they put a short timeframe around it, which leads to more uncertainty.

“You can achieve greater certainty when you lengthen the notes.”

That’s because a market downturn may have already ended by the time the notes mature, he explained.

“Once you go through a cycle, things tend to normalize,” he said.

Credit Suisse Securities (USA) LLC is the agent.

The notes will price on Sept. 30 and settle on Oct. 5.

The Cusip number is 22548QFL4.

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