Credit Suisse readies twin worst-of offerings with unlike levels of risk due to correlation

By Emma Trincal

New York, March 25 - Credit Suisse AG is preparing two worst-of deals with very similar terms but a significant difference in risk based on correlation, a determining factor used to evaluate such products, sources said.

The first deal is linked to two U.S. equity benchmarks and is seen as less risky than the second, an international equity-based structure. The added risk in the global equity product is due to a lesser degree of correlation between its two underlying components, the sources noted.

Both structures have the same issuer, maturity date and worst-of type of payout. Only the respective pairs of underlying components, leverage factors and knock-in levels vary, reflecting different amounts of risk.

Two deals

Credit Suisse plans to price 0% accelerated barrier notes due April 13, 2018 linked to the S&P 500 index and the Russell 2000 index, according to a 424B2 filing with the Securities and Exchange Commission.

If the final level of the lowest-performing index is greater than or equal to its initial level, the payout at maturity will be par plus 160% to 170% of that index's return. If the final level of the lowest-performing index is less than the initial level but greater than its knock-in level (70% of its initial level), the payout will be par. Investors will be fully exposed to losses from the initial level if the lowest-performing index falls to or below the knock-in level.

In the second Credit Suisse deal, the two underlying components are the Euro Stoxx 50 index and the iShares MSCI Emerging Markets exchange-traded fund. This fund trades on NYSE Arca under the ticker symbol "EEM."

The upside participation rate will be between 225% and 235%. The knock-in level is expected to be 60% of the initial level.

Dean Zayed, chief executive officer of Brookstone Capital Management, said he likes the structures.

"I've seen these worst-of where they pay a coupon. This is a similar idea but with the leverage instead," he said.

"The correlation between the two underlying is key. You're going to be more comfortable when the two indexes are correlated, which is the case with the U.S. deal in this case, and that's a good thing for the notes."

Correlation and risk

The correlation coefficient between the Euro Stoxx 50 and the iShares MSCI Emerging Markets fund is 0.32 with 1 being a perfect correlation. Between the S&P 500 and the Russell 2000, the correlation coefficient is 0.86.

In a worst-of note, the payout is not linked to a basket, in which the weighted average of the components would mitigate the risk, the prospectus explained in its risk section.

To the contrary, investors see their return directly linked to the worst performer, which creates another layer of risk inversely proportional to the correlation between the two components, said Zayed.

"When you're using the worst-performing benchmark in determining performance, the more correlated the indices are, the stronger the notes because you've almost eliminated the worst-of component. The two indices are behaving almost like one benchmark. It leaves less room for surprise; it reduces the chances of having one index behaving oddly. The two are expected to perform roughly the same way, which makes your structure not so different from the typical product tied to a single underlying asset," he said.

Comparing the widely different correlation coefficients, Zayed noted that "the U.S. deal I would say is better given the correlations. ... Less leverage and [a] smaller barrier is the trade-off, but one that is justified."

Good terms

The structure and the terms employed in both products remain highly attractive, however, he said.

"If you compare it to a long-only, you're giving up on the dividends, but in exchange, you get great leverage and a huge barrier in both deals," he said.

"The four-year maturity is attractive. The leverage is very attractive. You have no cap, which is unusual, especially with that type of leverage. The barrier is very solid.

"The U.S. deal is even more favorable, that's for sure. There is a trade-off, which is that your performance is tied to the worst underlying component, but it's acceptable given the high correlation between the two U.S. indexes."

Worst-of payout

Jonathan Tiemann, president of Tiemann Investment Advisors, LLC, agrees that the U.S. worst-of note is less risky, but he said that he is uneasy with the structure applied to both products. The worst-of payout in his view involves a level of risk difficult to assess even when a higher correlation coefficient may be able to reduce it.

"Both indexes have to be positive to get the benefit of the leverage, and you get the leveraged return on the poorer performance," he said.

"If either one drops more than the knock-in level, you get the worst of the worst.

"This is the kind of thing that may be worth it if you have a view, although I'm not even convinced of that. You would have to be bullish on both, but in this case, why wouldn't you buy both? I guess the asymmetrical leverage, the fact that you get enhanced return on the upside and not on the downside, may make it more compelling than a leveraged ETF."

Hidden leverage

"But I would submit that the structure gives you some sort of leverage on the downside too and that the leverage on the upside is less appealing than it appears because of the combination of risks," he said.

"For instance, if the Euro Stoxx was down 20% and the EEM down 40%, you would lose 40%. A basket would have mitigated the risk with the averaging. Here, you are stuck with the worst of the two. I think it's some sort of downside leverage in a way.

"So that's one problem."

The "second problem," he said, is that the structure does not allow investors to hedge properly.

Anti-diversification

"If you are a long-term portfolio manager who invests in both the Euro Stoxx and the EEM because they're less than perfectly correlated, if you seek diversification, buying this note would undo this sort of benefit," he said.

"If you were sure that the dollar would be trash in four years, you may use the Euro Stoxx/EEM notes because you could get a little boost out of the currency effect. But this would certainly not warrant taking the risk of the worst-of.

"So at the end, such product would not hedge anything."

Better off with the U.S.

Comparing both deals, Tiemann concluded that the international equity note is the "worst" of the two.

"I don't like any of the two, but if I had to pick one, I would prefer the U.S.-based note. You pick up a little bit of extra risk but for a meaningful amount of leverage. If you're really bullish on the U.S. markets, that might make sense," he said.

"The international one has little appeal. The risk that goes along with it is pretty big. Also, it's a risk that's very difficult to assess because the correlation is so much lower.

"These two deals, which at first look very similar, are actually quite different from each other because of the difference in correlation.

"For any investor looking at those worst-ofs, my advice would be to pay extra attention to correlation. It may make more sense to use a product tied to two highly correlated indices because it mitigates the risk quite a lot and you may still get a decent payout."

Credit Suisse Securities (USA) LLC is the underwriter.

Both offerings are expected to price April 10 and settle April 14.

The exact knock-in levels and participation rates will be set at pricing.

The Cusip number is 22547QL20 for the notes linked to the S&P 500 and the Russell 2000 and 22547QL38 for the notes linked to the Euro Stoxx 50 and the emerging markets fund.

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