Credit Suisse’s Bares linked to Vanguard REIT ETF: structure is strong, but risk is high

By Emma Trincal

New York, July 22 – Credit Suisse AG’s 0% Buffered Accelerated Return Equity Securities due July 28, 2016 linked to the Vanguard REIT exchange-traded fund offer a very attractive payout, sources said, but the interest rate risk and high valuations associated with the underlying sector may represent significant risks despite the buffer.

The payout at maturity will be par plus 175% of any fund gain, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by 10% or less and will lose 1.1111% for every 1% decline beyond 10%.

“This is an attractive note given the fact that it has great leverage to the upside, is uncapped and is only two years in duration,” said Dean Zayed, chief executive of Brookstone Capital Management.

“This product would appeal to an investor who is bullish on the real estate sector and would like a more tailored method of getting this exposure. We run several tactical strategies, and we actually own this underlying ETF in several of them. Obviously, this indicates that we are bullish on real estate today and have been for some time, so we have partaken in nice gains that VNQ has provided.”

The Vanguard REIT ETF is listed on the NYSE Arca under the symbol “VNQ.”

The fund is up nearly 19% this year to date, outperforming the S&P 500 index by more than 10 percentage points. Over the past 12 months, however, the return is below 6% due to a sell-off triggered by the Fed’s tapering announcement.

Sector is rich

Given the returns, Zayed stressed the risk of a pullback.

“The 10% buffer is not that high, and the leveraged downside could be problematic in the event of a major market correction,” he said.

One way to be more cautiously bullish on REITs is to invest in more liquid instruments, he said.

“We’re bullish on the sector, but the problem with the note structure, unlike the ETF, is that we can sell the ETF anytime our indicators turn off on VNQ. This is not necessarily true with the note, where liquidity becomes an issue. We tell all of our clients that the expectation when buying any note is to hold it until maturity,” he said.

High valuations and the subsequent risk of a correction are not only a concern for investors having exposure to REITs but to equities in general, he noted.

On Tuesday, the S&P 500 index during the day hit an intraday record high of 1,986.24.

“Here’s the bottom line: the terms of this note are attractive,2 and the underlying is something we actually own currently. But given the maturity of this bull market and the volatility that real estate as a sector can have, investors need to be careful because two years can actually be a long time if a bear market suddenly rears its ugly head,” he said.

Not just for yield

For Paul Weisbruch, vice president of ETF/options sales and trading at Street One Financial, the REIT sector has shown such a stellar performance that it remains unclear whether investors get exposure to the sector for the yield as they traditionally have or for the capital appreciation.

“In the past, the purpose for these investments was the yield, but the sector has had such a run that yields are relatively low at this moment from what they were two years ago,” he said.

The distribution yield of the Vanguard REIT ETF is 3%. As it is normally the case with structured notes, the prospectus specified that noteholders are not entitled to receive cash dividends available to direct equity investors.

“Since the notes give you exposure to the price return of the index, it seems like it’s not really a yield play,” Weisbruch said.

“I see it more as a bet against a sharp decline in the sector. You have 10% insurance, and then the leverage factor applies if it goes down more than that.

“People buying this note probably are making a statement that the sector will continue to show steady growth and not experience a significant drawdown.

“Is it risky? Well, this is a sector that is at all-time highs, just like the market itself, so 10% is not going to protect you against a correction. If you’re buying this note and betting on this sector, I think it’s fair to say that you’re ruling out the idea of a correction anytime soon, at least in the next couple of years.

“This view reflects the new normal environment in which we are. A 10% correction is almost unfathomable in this market. We haven’t even had a 1% correction. If the investor is relatively bullish and if volatility remains subdued, the two-year term with 10% protection stands out. After that, however, the landscape can change dramatically in terms of how high the rates will move up, where people will be investing and where they’ll be looking for yield.”

Interest rates

A second concern for investors should be interest rate risk, sources said. The prospectus stated the risk itself by saying that changes in interest rates pose a risk for the real estate sector.

Weisbruch said the risk is hard to assess as it is very dependent on monetary policy.

“I would argue that the risk of a drawdown would depend on how disruptive a rise in interest rates would be,” he said.

“I’m not sure you can even forecast that short term. People have been forecasting higher interest rates over the past five years, and it hasn’t materialized. Everyone is taking their cues from the Fed, and it’s hard to say what the sector will be doing next.”

But Todd Lukasik, Morningstar's senior REIT analyst, said that the strong bullish momentum seen in the sector may come to an end if interest rates rise.

“We think that rising interest rates represent a valuation risk for investors in the REITs space,” Lukasik said.

“Interest rates if they go up will be a valuation headwind for REITs for sure.

“Our preference in terms of investing in a potentially rising interest rate environment would be to invest in the REITs that have the most growth prospects and the best balance sheet.

“That would speak more to stock-picking as opposed to investing in an index fund directly or indirectly.”

Lukasik covers all the stocks making the top 10 holdings in the Vanguard REIT index, which represent 40% of the index portfolio.

The downward move in interest rates seen this year contributed to the bullish performance in the REIT sector, he said.

Watch the 10-year Treasury

“The fund has performed very well this year. At the same time, the yield on the 10-year Treasury went from 3% at the start of the year to less than 2.5% today. We think the strong rally in the fund is consistent with our view,” he said.

“If interest rates do go up, REITs valuations will be under pressure. On the other hand, we see that the 10-year yield has dropped by more than 50 basis points, and we think a lot of that contributed to make the REITs one of the best-performing sectors year to date.”

So far, part of investor interest in REITs has been that they can provide not only yield but capital gains.

“But they should keep in mind the role of interest rates in valuations. We do think that the price for REITs is likely to move inversely with the yield of the 10-year Treasury,” he said.

“I don’t know the specifics of this note, but if the performance is going to be linked to the price change of U.S. REITs, I would assume the product would be subject to valuation risk in a rising interest rate environment.”

Credit Suisse Securities (USA) LLC is the underwriter for the notes, which will price Wednesday and settle Monday. The Cusip number is 22547QQT6.

Simon Property Group Inc. is the underlying fund’s top holding with an 8.6% weighting. Public Storage is No. 2 with a 4.1% weighting followed by Equity Residential with a 3.6% weighting.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.