Credit Suisse’s 6.05% contingent coupon autocalls on index, funds offer low barriers, income

By Emma Trincal

New York, Jan. 5 – Credit Suisse AG, London Branch’s contingent coupon autocallable yield notes due July 12, 2019 linked to the least performing of the Russell 2000 index, the iShares MSCI Emerging Markets exchange-traded fund and the SPDR S&P Oil & Gas Exploration & Production ETF introduce more risk with the use of three underlying in a worst-of structure. But the structure helps mitigate the chances of losing money, said Suzi Hampson, structured products analyst at Future Value Consultants.

The notes will pay a contingent quarterly coupon at an annualized rate of 6.5% if each underlying component closes at or above its 70% coupon barrier on an observation date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par if each component closes at or above its initial level on any quarterly call date after six months.

The payout at maturity will be par unless any component finishes below its 60% knock-in level, in which case investors will be fully exposed to any losses of the worst performing index or fund.

Three, not two

This worst-of differs from most similar products seen in the United States in two ways, Hampson said.

“Most of the time, maturities are longer. This looks a little bit more like a reverse convertible in terms of the tenor,” she said.

Second, those products usually are linked to the lesser performance of two underliers rather than three.

“Three assets is not unheard of. But it’s less common,” she said.

“The more underlying you have, especially not particularly correlated ones like here, the more downside risk and higher chances of missing a coupon you have. In addition, your potential chances of being kicked out are lower.”

Little correlation

Between the Russell 2000 index, which measures the return of U.S. small-cap stocks, the iShares MSCI Emerging Markets ETF, an international equity fund and the SPDR S&P Oil & Gas Exploration & Production ETF, a sector fund with a strong relationship with the price of oil, correlations are only 0.6, she noted.

The fact that three underlying assets have to be above certain levels in order to generate positive scenarios such as coupon payments, automatic call and full principal repayment at maturity makes this product apparently more risky than many similar ones, she said.

“In addition, the correlation between those three assets is not high.”

One may think that the contingent coupon rate of 6.05% could have been higher given the low correlation between the assets and their number.

Structural advantages

But the structure offers several features, which make the product more compelling from a risk-adjusted return standpoint, she noted.

“You have a six-month no call. Each quarterly coupon pays 1.5%. Since the greatest probability of being called in any autocall is always on the first call date, this six-month no-call guarantees you at least 3% instead of 1.5% should you be called on the first date, which is more appealing,” she said.

Moreover, the coupon barrier increases the chances of getting paid.

“A 70% coupon barrier is at a pretty low level. Your chances of getting your coupon are pretty high,” she said.

Finally, the 60% barrier at maturity is also relatively conservative, she added.

“Even though you have three underlying, the rest of the product seems less aggressive. It’s kind of a trade-off,” she said.

Scorecard

Future Value Consultants generates stress testing reports for structured notes. Hampson illustrated some of the remarks using one of the 29 tables included in each report – the investor scorecard.

The scorecard, made up of a number of different mutually exclusive outcomes of product performance, shows the probability of occurrence and average return among other statistics.

The different outcomes, which vary by structure type and terms, derive from a Monte Carlo simulation.

Three outcomes

For this product, the scorecard displays three possible outcomes: the notes may be called on five occasions; investors may receive their principal back at maturity; or they may lose all or some of it.

The call scenario is broken down into five “call points,” since the first quarter is skipped.

The call at point one, in other words after six months, is expected to occur a third of the time, according to the scorecard. After that, probabilities decrease progressively.

“Your probabilities of being called after the first observation always decline with time if the call level stays the same. The only time when it might increase is if you have a step down,” she said.

She referred to autocallable structures with declining call thresholds.

“But even with a step down, the probabilities do not increase a lot because you’re already down.”

Third asset impact

A comparison between this product and worst-of autocallables linked to two assets illustrates the additional risk that comes with the inclusion of a third underlier.

“Usually the chances of a call on the first call point are in excess of 50%. Here it’s only 33% of the time,” she said.

“That’s the correlation risk: now you need all three underlying to be above their initial price and there’s not a high correlation between those three.”

Future Value Consultants in its model uses four market scenarios – bull, bear, low volatility and high volatility.

The scorecard is based on the neutral scenario, which is the basis for pricing and is calculated from the risk free rate, dividend yield and implied volatility.

The neutral scenario is using a less aggressive growth assumption for the underliers than the bull scenario. But the nature of the product made the difference not very relevant.

“It won’t make a big difference because you’re not dealing with an accelerated note,” she said.

“All you need is the three underlying to stay above a certain barrier.”

No call, no losses

The second main outcome – full capital return – is expected to happen 34% of the time, the scorecard showed.

In this scenario, the notes mature and the worst-performing asset finishes between 60% and 100% of the initial price.

“You haven’t called and you’re not receiving your final coupon. But you have been paid during the life,” she said.

The average payoff in this case is 107.7% for the 18-month term, or nearly 5.15% a year, according to the simulation.

Barrier breach

The third outcome, or loss scenario, occurs when one of the underlying breaches the 60% barrier at maturity. Such outcome is not very likely (10.78% of the time) but the average loss is 51.5%.

“The probability of losses is rather small, especially given the fact that you have three uncorrelated assets,” she said.

On the other hand, the size of the losses in average is substantial.

“It’s a pretty bad outcome if it happens. But it’s predictable. You have a 60% barrier. If you lose, you know you’re going to lose at least 40% of your money,” she said.

A barrier breach leads to an average loss of 50%, according to the scorecard.

“It’s quite drastic. But it’s not very likely,” she said.

“It’s always going to be the case anytime you have a low barrier. The point of having a defensive barrier is to reduce the odds of such outcome.”

In conclusion, Hampson said the notes were designed to help investors cope with a low interest rate environment.

“It’s an income product definitely for someone looking for yield,” she said.

“There is not any easy way to get a 6% a year in this market unless you look for something a little bit inventive.

“Rather than investing in the three underlying directly, you get a fixed return with a low coupon barrier, giving you a better chance at getting paid.

“By taking advantage of the correlation, you get a competitive interest rate as well as a generous barrier.

“If you’re not called, your losses could be hefty. But this worst-case scenario is one of the least probable. But it is painful.”

Credit Suisse Securities (USA) LLC is the agent.

The notes will price on Tuesday and settle on Friday.

The Cusip number is 22550W3T2.

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