Credit Suisse’ leveraged notes tied to S&P 500 offer good pricing but cap seen as a bit low

By Emma Trincal

New York, Nov. 21 – Credit Suisse AG, London Branch plans to price 0% leveraged buffered notes linked to the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are expected to mature between 24 and 27 months after pricing.

If the index return is positive, the payout at maturity will be par plus 150% of the index return, subject to a maximum settlement amount of $1,144.00 to $1,168.75 per $1,000 principal amount of notes.

Investors will receive par if the index declines by 10% or less and will lose about 1.1111% for every 1% that the index declines beyond 10%.

Standard product type

“It’s a very standard product, a typical leveraged return note, which is how we categorize this in our database,” said Tim Vile, structured products analyst at Future Value Consultants.

“The two-year term is about right. Most leveraged return notes are between two and three years. This one is slightly on the shorter end but still standard.”

The terms in the prospectus indicate a fixed rate of upside leverage of 1.5. But the cap, to be between 14.40% and 16.875%, will be set at pricing, he observed.

By convention, Future Value Consultants choose hypothetical caps 25% below the upper range, which gives an assumed 16.25% maximum return used to generate the research report, he explained.

Mild bulls

Based on these parameters, the annualized cap on a compounded basis is 7.82%.

“It’s just about an 8% return per annum. With the leverage, it would only require the S&P 500 to increase by 5.30% a year in order for investors to hit the cap,” he said.

“That’s really not a lot, which is why the notes are for a limited category of bullish investors – those who do not expect the index to do much. The outlook is bullish but mildly bullish only. If someone was really bullish, the no-cap or higher cap solutions would be the preferred options.”

Little volatility

The cap level is a function of the volatility of the underlying asset, he noted.

“The notes are tied to the S&P, which has a relatively low volatility compared to single stocks or even to other benchmarks, both in the U.S. and outside of the U.S.,” he said.

“If we had more volatility in the underlying, there would be a greater potential for wider moves in the asset price, making the call option more expensive. By selling the call, you would be able to raise the cap much higher than what you get here with an S&P-based product.

“Because it’s the S&P and not a stock or a more volatile index, we have less money to play with for the cap, which is why we only get 8% a year. It’s still better than the risk-free rate but this is also a capital-at-risk equity product.

“On the other hand, this cap level is achievable with only a modest rise in the index, obviously a plus for mildly bullish investors.

“The S&P 500 is a very established index. It has shown a strong growth and the maximum return can be easily reached in a bull market since the leverage requires only a reasonable amount of growth, just south of 11% for the two-year period,” he said.

Geared buffer

One of the important aspects of the structure was the establishment of a 10% buffer on a relatively short-term product, he noted.

“You have a real buffer on the downside,” he said.

“If the index drops by 10%, your capital is still safe. You get 100% of your money back in the absence of a negative credit event.

“Any further than 10%, your capital is at risk. The 1.11 times downside gearing accelerates the pace of losses after the 10% threshold, but it’s still a buffer. You only lose for each point after 10% not from the initial price.

“However, since the losses compound at a rate of 1.11, you can end up losing your entire principal, which wouldn’t happen if there was no gearing. A one-to-one 10% buffer would guarantee 10% of your principal.

“The gearing introduces more risk, which is why the issuer can sell the option on the downside for more premium. There is as a result more money available to spend on the calls.

“If instead of that you had a buffer on a one-to-one basis, most likely the cap would have been lower. Or the leverage on the upside would have been reduced or cut. In any event, the issuer would have had to play around in order to make up for the cost of the call. The potential return would have been reduced,” he said.

Buffer versus barrier

Investors typically prefer buffers to barriers but they should always look at pricing and compare the two features based on their own market assumptions, he said.

“The equivalent of this 10% geared buffer would be a barrier but a deeper barrier. Let’s say for instance that you have a 60% European barrier instead of this 10% geared buffer. The choice between the buffer and the barrier really depends on how the investor looks at it,” he said.

“In this example, if the index drops by half, the buffer would generate a 44.45% loss. The barrier on the other hand would make you lose half of your money, because the index would have dropped by more than 40%.

“Now let’s assume you have a 50% European barrier. Obviously, all things being equal, you’re better off with the barrier as you would recoup your entire principal instead of losing 44.45%,” he said.

Good pricing

For each product, Future Value computes a price score that measures the value to the investor on a scale of zero to 10.

This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

Because the fees are annualized, a longer-dated product will benefit more from this methodology, he explained.

The price score of the notes is 7.62 versus 7.60 for the average leveraged return note.

“This product has a price score slightly higher than the average for all products of 7.41. But the score is in line with notes in this category of products. It suggests the notes were priced reasonably well,” he said.

The “all-product” category includes all notes recently rated by Future Value Consultants across all structure types.

Cap eyed

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions – neutral assumption, bull and bear markets, and high and low volatility environments.

The return score is calculated based on the best among the five return scenarios, which for this particular product would be bullish.

The notes show a lower return score of 7.16 compared to 7.74 for the average for this product type, according to the report.

“The return score here is below average. It’s partly due to the cap. We run the bullish scenario to score the risk-adjusted return and it’s obvious that the cap along with the short duration do not give the product enough of a chance to show a strong performance. A more bullish investor under this scenario would look for a higher cap or no cap at all,” he said.

Defensive risk profile

Future Value Consultants assesses the risk associated with a product by adding two risk components – market risk and credit risk. The resulting riskmap measures risk on a scale of zero to 10 with 10 being the highest level of risk possible.

The market riskmap of 2.05 compares well with the 2.75 average market riskmap for the product type, the report showed.

“The notes are less risky than the average product partly due to the buffer as it keeps your investment safe up to the first 10% of index decline,” he said.

Another factor is the relatively less volatile underlier compared to others used in this product type, he added.

“The existence of a buffer combined with a less volatile underlying is giving you a more defensive product than the average leveraged return note,” he said.

In terms of credit risk, the product also scores better than its peers with a 0.43 credit riskmap versus 0.56 for the product type, according to the report.

“There is not a huge difference but still, we have less credit risk and that’s probably due to the issuer’s credit along with the relatively short duration. Both factors reduce the odds of a default,” he said.

By adding the market riskmap to the credit riskmap, the report reveals a subdued riskmap of 2.48, almost one point lower than 3.30 – the average for the product type.

Slightly below average

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The overall score for the notes is 7.39 against 7.67 for the product type.

“It’s less because of the lower return score,” he said.

“The cap level has not helped the return score. A higher cap, even if it slightly increases risk, would certainly have improved the return score.

“The difference in overall score between this product and its peers is not huge. Still, the notes would have benefited from more upside potential,” he said.

Credit Suisse Securities (USA) LLC is the agent.

The notes are expected to price on Tuesday.

The Cusip number is 22547QWY8.

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