Credit Suisse’s Bares tied to S&P 500, Russell use worst-of to generate premium, higher cap

By Emma Trincal

New York, June 16 – Credit Suisse AG, London Branch’s 0% Buffered Accelerated Return Equity Securities due Aug. 1, 2018 linked to the lowest performing of the S&P 500 index and the Russell 2000 index illustrates that worst-of structures are not strictly limited to contingent coupon notes or other income-type of products, said Suzi Hampson, structured Products Analyst at Future Value Consultants.

“Although it’s not very common, they’re using a worst-of here in a leveraged note so you can get some participation in the appreciation of the relevant index,” she said.

If each index finishes at or above its initial level, the payout at maturity will be par plus 150% of the return of the worse-performing index, up to an underlying cap of 9.5% to 11.5%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if each index falls by no more than 10% and will lose 1% for each 1% decline of the worse-performing index beyond 10%.

Less common

“It’s more common to see worst-of in reverse convertibles or autocallables. In general they’re used for trigger products, in which you need to reach a certain level for something to happen,” she said.

The worst-of adds some risk, she said, since the exposure is to the worst-performing index.

One “good thing for the investor,” she said, was the high correlation between the S&P 500 index and the Russell 2000.

“We would expect that from the choice of the two indices, both U.S. equity indices,” she said.

Correlation

“It works in favor of the investor as it limits the risk a little. When two indexes are not correlated, one of the two may drag down your performance at the end.

“It takes two indexes to be positive but it only takes one to be negative. That’s why you have less risk when both tend to move in the same direction.”

A worst-of structure will look very different in a leveraged return product than in an autocallable, she said.

“Here you need both to finish positive. You need both to get paid,” she said.

“With the autocall, we’re asking the two underlying not to do something...not to hit the barrier, or not to fall below the initial price.”

Bullish

But the additional risk helps raise the cap, she noted.

“Just like people use worst-of to boost the coupon, it’s being used here to give you a higher cap.”

She chose a 10.5% hypothetical maximum return to run for the purpose of running her model.

“The participation is modest with 1.5 times although it’s only one year. But the cap is relatively high. This kind of combination usually targets the more bullish investor,” she said.

Future Value Consultants produces stress-test reports on structured notes. Each report includes a number of tables offering probabilities of occurrence for specific outcomes with average payouts. The model runs a forward-looking Monte Carlo simulation used under a “neutral” scenario. In some tables, other hypothetical market assumptions are used, which include bear, bull, less volatile and more volatile markets.

Product specific tests

One section called “product specific tests” displays the probabilities of the outcomes inherent to the studied structure. For this leveraged buffered note with a cap, the main event is whether investors will receive the maximum return.

This simulation is performed under a neutral market scenario.

The table shows a 29.76% probability of hitting the cap under the neutral assumption. In a bull market, the odds increase to 43.53%. Naturally the bear market sees the probability of such event drop to 17.64%.

“As you would expect the bull is the best outcome. The bear is the worst but you may have thought it would be much worse,” she said.

The explanation lies in the assumptions used to calculate market growth rates in each market.

“Our bull scenario is quite conservative. Our bear scenario is not very negative. We want to look at things in a symmetrical way,” she said.

Backtesting

A look at the same table, but on a backtesting basis, with results over the past five, 10 and 15 years, shows much brighter results.

The probabilities of reaching the cap jump to 62.28% for the past five years. It drops to nearly 54% in the past 10 years and 56% in the past 15 years.

“The last two periods – 10 and 15 years – have seen the bear market of 2007-08. But we’ve had a very long bull run since then. These probabilities reflect how those underlying have performed over the past,” she said.

She noted that the simulation illustrated in the product specific tests is performed under various market scenarios while the backtesting is calculated under the neutral assumption only.

“And yet, what we find under the neutral assumptions with the backtesting shows much better results, higher probabilities of reaching the cap than what we find when we run the simulation under the most optimistic market scenario, the bull assumption,” she said.

Buffer role

Another report, called the scorecard, shows other possible outcomes, such as receiving full capital return, positive return and capital loss.

Investors have much greater chances with this product than they would with an autocallable to receive exactly 100% of their investment, she said.

“It’s simply because of the 10% buffer,” she said.

This probability amounts to 21% under the neutral scenario.

“The buffer is doing something. It’s not worthless. All these times, 21% of the time, you would have lost capital without it,” she said.

The chances of losing money – investors can lose up to 90% of their capital – are not small, she said with a 31% probability.

Finally there is an 18.2% probability to get a positive return. As outcomes are mutually exclusive, this last test does not include receiving the maximum return.

Alternative to low vol.

“Like any structured note, this one represents an effort to increase the return while still trying to control risk,” she said.

But rather than using volatility in a U.S. equity market characterized by low volatility levels, the issuer has employed a worst-of option as a way to generate premium.

“An alternative could have been to sell volatility on a stock,” she said. “But who wants a volatile stock? People like equity indices.

“The worst-of gives the issuer some flexibility. It’s a different approach. You’re taking correlation risk rather than volatility risk. If the investor is comfortable with both indices and comfortable with the concept, you can actually offer quite a high cap.”

However, worst-of have their own limitations.

“The payoff is quite hard for investors to quantify and the results can be unexpected,” she said.

Credit Suisse Securities (USA) LLC is the underwriter.

The notes will price on June 27 and settle on June 30.

The Cusip number is 22550B6U2.

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