Credit Suisse prices top deal with $225.9 million return notes tied to Select Sectors, S&P 500

By Emma Trincal

New York, Feb. 12 - Credit Suisse AG, London Branch brought to market the largest deal of the year so far last week in what sources said is an unusual structure expressing a bullish, tactical view on three sectors.

J.P. Morgan Securities LLC and JPMorgan Chase Bank, NA were the placement agents.

Credit Suisse priced $225.9 million of 0% return notes due Feb. 25, 2015 linked to the upside return of an equally weighted basket of three Select Sector indexes and the downside return of the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

The basket consists of the Select Sector Financials index, the Select Sector Industrials index and the Select Sector Technology index.

The return of the notes is linked to the upside return of the basket leveraged at a 1.09 rate and to the depreciation of the S&P 500 on a one-to-one basis, according to the prospectus.

Upside, downside

"That's interesting. So there is a tiny bit of leverage and no downside protection," a structurer said.

"You don't get exposure to the S&P gains. And you don't get penalized at all if the basket goes down. That's unusual."

The prospectus offered some examples to illustrate how the payout works.

If the S&P 500 declines by 50% while the basket remains flat, investors will see their investment lose 50% of its value, for instance.

If the basket gains 30% and the S&P 500 declines by 10%, investors will receive the leveraged upside return of 32.7% while losing 10% on the downside, resulting in a net gain of 22.7%.

"This product was probably created out of JPMorgan research with analysts identifying some of their favorite sector picks, betting that those would outperform the S&P," a market participant said.

"People are becoming more tactical. There is a lot of talk about breakdown of correlations. We've already seen defensive names outperforming other sectors. Essentially, you're getting the outperformance of those picks."

Bullish

The investment, according to this market participant, is a "fundamentally bullish play" because investors do not expect any negative performance from either the S&P 500 or the basket. They are only willing to forego the upside on the S&P 500 based on the tactical view that the average return from the three sector picks will outperform the market.

"You're fundamentally bullish on the market, and it's a leveraged play," he said.

Investors in the notes "can't be bearish," he said. That's because if both the index and the basket decline, investors will lose money by virtue of being exposed to the negative return of the S&P 500. And if only the S&P 500 drops, any positive return in the basket will be reduced by the amount of the index decline.

"What you really want is the basket to be up. But you also want the basket to rise more than the S&P since you're not getting any positive exposure from the benchmark," this market participant said.

"The play is a breakdown in correlations. Last year if you bought the S&P ETF, you were doing fine. Now it's not about owning the market. It's about owning stocks and sectors that will outperform the market. Your view is that some sectors will be up 5%, 10% or 20% while the S&P will be up slightly less or even flat."

Quasi-delta one

A sellsider said that the structure is nearly "delta-one" despite the 1.09 leverage factor offered on the upside.

A derivative offers a delta-one return when there is hardly any difference between the price of the derivative and that of the underlying. In this case, the downside return has a delta of one while the upside has a delta of nearly one, with the small leverage factor representing the only optionality in the product.

The sellsider explained how the issuer was able to price this small optionality component.

"You're long at-the-money calls on the basket and short simple at-the-money puts on the S&P. You're actually long 1.09 calls on the basket. That's the leverage," he said.

The leverage factor was financed using the unpaid dividends, he explained. The dividend yield for the S&P 500 index is about 2%. He assumed a similar dividend yield on the basket.

"The at-the-money spot price of 100 will be 98 because the S&P options don't reinvest dividends. As a result, buying the calls on the three sectors, assuming they have the same dividend yield, will give you a 2% slightly out-of-the-money position with the calls," he said.

"It lowers the cost of buying those calls, and that's where the leverage comes from.

"But 1.1 times isn't much. You can say that it's a quasi-delta one structure. The correlation between the index and the basket is high.

"This is for a bullish investor who would happen to be more bullish on some sectors within the S&P. The idea is that financial, industrial and technology stocks will outperform other sectors, such as energy or consumer discretionary for instance. You're betting on some sectors against some others."

The notes (Cusip: 22547QHK5) priced Friday.

The fee was 1%.

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