Credit Suisse's reverse convertibles tied to VMware offer fixed income based on neutral view

By Emma Trincal

New York, May 16 - Credit Suisse AG's 8% autocallable reverse convertible securities due June 2, 2015 linked to the common stock of VMware, Inc. are structured to provide a fixed monthly interest payment to investors who hold a neutral view on the underlying stock and are willing to accept the possibility of early redemption if the notes are automatically called, said Tim Mortimer, managing director of Future Value Consultants.

The notes will be called at par if VMware shares close at or above the initial share price on Nov. 26, 2014 or Feb. 25, 2015, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par unless VMware shares close at or below the knock-in price, 75% of the initial share price, during the life of the notes and finish below the initial share price, in which case the payout will be a number of VMware shares equal to $1,000 divided by the initial share price.

"The notes are for someone looking for yield who would be confident that the stock wouldn't go down more than 25% for the lifetime of the deal," said Mortimer.

The investor would not be too bullish on the stock as to miss the excess return over the coupon payment but could be slightly bearish as long as the stock does not breach the 75% knock-in price.

Fixed rate, variable term

Mortimer described the product as a short-dated reverse convertible with a variable term.

"It's a one-year tied to VMWare. It's like a reverse convertible but with a variable duration. You'll get a monthly coupon at an annual rate of 8%. It's a fixed rate. You can get 104% if you're called after six months and 106% after nine months. This is not the standard autocallable, which is based on a contingent coupon payable if the notes are called or if they're above a certain coupon barrier. With this product, you're actually getting the coupon. If the notes are called, investors will only receive the accrued interest," he said.

Future Value Consultants in its research, assess risk, return and price using a variety of proprietary scores in order to compare a product with others. Each product belongs to a category or product type, which reflects the structure being used. Comparisons are established against all products but more usefully against the average of the category.

The Credit Suisse notes fit into the "review reverse convertible" category in Future Value Consultants' methodology, said Mortimer.

Review reverse convertibles are notes that pay a fixed coupon but have a variable maturity due to the autocall, he explained.

"Pure autocallables with a contingent coupon will pay more than this type of product because investors receive a premium when the coupon is contingent upon a trigger event. You get paid more for the risk of not getting anything. That's why autocallables are more popular than standard reverse convertibles in today's low yield environment. They give you a higher yield to compensate you for the uncertainty," he said.

Implied volatility, barrier

The notes were tied to a stock showing an implied volatility of 28%.

"It's not hugely volatile compared to other stocks but you have to measure it against the other review reverse convertible notes we have scored this product against. The volatility in relative terms will determine whether the 8% coupon is sufficient to compensate for that amount of risk if you look at this product versus its peers," he said.

The knock-in is an American barrier, he noted.

American-style barriers are observed on any trading day and not just at maturity as it is the case with European barriers.

"American barriers are common for reverse convertibles although you do see both American and European barriers," he said.

"There is obviously more risk involved with the American barrier than the European barrier. But on shorter-dated deals, the difference between the two is not that great although the probability of falling down by more than 25% any day will be a function of volatility."

Mortimer said that an implied volatility of 28% is not excessive for a stock tied to a reverse convertible.

"We've seen much higher levels with notes linked to oil or technology stocks," he said.

Recent deals according to Prospect News show reverse convertibles tied to the shares of Facebook, Inc., a stock with a 38% implied volatility, or tied to Tesla Motors, Inc., a security with an implied volatility of 45%.

Future Value Consultants' ratings compare a product versus the market at a particular time and versus similar products, Mortimer said.

"In this category of notes, we currently have a fair amount of index-based notes as well as notes tied to less volatile stocks. So if this product competes with less volatile ones, the difference will be reflected in our risk score.

"This is why we end up with a much higher market risk according to our market riskmap."

Riskmap

Future Value Consultants' riskmap is a score measuring on a scale of zero to 10 of the risk associated with a product with 10, the highest level of risk possible. The riskmap is the sum of two risk components: market risk and credit risk.

The notes have a 4.30 market riskmap compared to 2.80 for the average of the same product type, according to the report.

The credit risk of 0.24 however is in line with the average of 0.29.

Given the gap between this product and its peers on the market risk scale, the riskmap ends up higher as well at 4.54 versus 3.09.

Return score

Future Value measures the risk-adjusted return with its return score. The rating is calculated using several market assumptions. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best scenario.

The return score of this product is 5.61, the report showed while the average return score for this product type is 6.38.

"With the volatility being high compared to similar structures, the probability of losses is quite significant," he said.

"The amount of losses is also likely to be significant because once your stock declines by 25%, you have to go back up by maturity and it can be quite a steep move on such a short amount of time."

Price score

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.

The price score for the notes is 5.02 versus 7.03 for the average of the same product type.

"The low price score is in line with the return. For this product, all other notes are pretty much built around the same structure. It's pretty standard. Since the volatility is higher compared to the yield that's being offered, it will affect the value and the return in a similar fashion," he said.

Overall score

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 notes have a 5.31 overall score, which is nearly one-and-a-half point less than the average for the same product type.

"Our model shows that the 8% yield is not sufficient to compensate investors given the high volatility of the stock. Another 2% would get the notes in par with the 6.71 average for this category," he said.

"While 8% looks good on a one year, this coupon should be evaluated based on the 30% volatility. It needs to be raised to match the average. Eight percent looks better than 6%. It's a good headline rate and that's why issuers find sufficient demand for these products. But on the value scale, it's not high enough."

The notes (Cusip: 22547QN69) are expected to price on May 28 and settle on June 2.

Credit Suisse Securities (USA) LLC is the agent.

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