Credit Suisse’s worst-of autocallables show slightly higher risk with three underlying ETFs

By Emma Trincal

New York, Nov. 1 – Credit Suisse AG, London Branch’s contingent coupon autocallable yield notes due May 5, 2023 linked to the least performing of the VanEck Vectors Gold Miners exchange-traded fund, the Energy Select Sector SPDR fund and the Technology Select Sector SPDR fund provide above-average yield but with significantly more risk given the number of underliers and the fact that they are not highly correlated to one another, said Suzi Hampson, head of research at Future Value Consultants.

Each quarter, the notes will pay a contingent coupon if each ETF closes at or above its knock-in level, 60% of its initial share price, on the observation date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The contingent coupon rate is expected to be 10% per year and will be set at pricing.

The notes will be automatically called at par if each ETF closes at or above its initial share price on any quarterly observation date.

The payout at maturity will be par unless any ETF finishes below its knock-in level, in which case investors will lose 1% for every 1% that the least-performing ETF declines from its initial share price.

Three assets

“This is your typical autocallable worst of, but with slightly more risk,” said Hampson.

She compared this structure with commonly seen worst-of notes linked to two correlated U.S. indexes, for instance the S&P 500 and the Russell 2000.

“You have three ETFs that concentrate stocks in a certain sector or industry: gold miners, energy and technology.”

The energy fund and the technology fund have the highest coefficient of correlation at 0.81, according to Future Value Consultants. In comparison, the S&P 500 and the Russell 2000 have a coefficient of correlation closer to 1 at about 0.95. The least-correlated underlying ETFs are gold miners and technology with a coefficient of correlation of 0.63.

“Gold stocks, energy and technology – all three sectors ... could be part of a diversified portfolio. But to combine them in a worst-of is quite a different idea,” she said.

“You’re not benefiting from the diversification because you’re only looking at the worst one. It’s a different proposition.”

Autocall less probable

For that level of risk, investors may collect a 10% coupon as long as the three underlying ETFs close above the 60% barrier.

“The 60% level applies to both the payment of the coupon and at maturity. It sounds quite defensive, and the 10% coupon is quite decent too,” she said.

But the probabilities of the automatic call occurring are not very high because of the choice of those three ETFs and their low correlations to one another.

“They all need to be above 100, which is not as easy when you have three assets,” she said.

A less likely autocall event may be more attractive for investors who want to collect the coupon for a longer period of time, she said.

“But it makes the product riskier as well. When your chances of calling are lower, you’re removing a risk-reducing piece in the structure,” she said.

“People usually like to get called and get their coupon simply because once you’re out, you no longer have any risk exposure.”

Stress tests

Hampson illustrated her points using the stress testing report she produced for the notes.

Future Value Consultants specializes in stress-testing analysis for structured notes. Hampson focused on one of the 29 tables included in each report, the product-specific tests. The probabilities displayed in this table are specific to the product type. The tests include the probabilities of barrier breach, the probabilities of call at various dates and the probabilities of contingent coupon payment.

In addition, the table features five distribution assumption sets, which are various market scenarios based on assumed growth rates and on volatilities for each of the underlying. Those scenarios are bullish, bearish, less volatile and more volatile. Another one, the neutral scenario, is the basis of the Monte Carlo simulation in all reports. It reflects standard pricing based on the risk-free rate.

Bullish assumption

To narrow down the analysis given the high number of different outcomes, Hampson focused on the bullish environment.

“We want to eliminate the neutral scenario as it’s risk neutral. It’s based on how the banks price the options,” she said.

“You don’t want to use it for prediction. Most clients when using the simulation have an outlook in mind. The preferred one here would be bullish.”

The annualized rate of growth for the energy, technology and gold miners funds are 5.3%, 7.3% and 8.2%, respectively, according to the report.

“We’re not really talking in market terms here. We’re just picking a reasonable growth rate for our model so we can make comparisons with other products more easily,” she said.

Call at point one

The first observation from the table under the bull scenario is a high probability of call at point one, or on the first observation, she noted. The chance of a redemption after only three months is 38.97%. The probability drops to 14% at point two and 7.36% at point three. There are 14 observations. The last point is at less than 1%.

“This distribution is typical of those products. The highest probability of calling is always and by far at point one. It then falls quickly as you move on,” she said.

But an important difference emerged when comparing this product’s highest probability with other worst-of autocallable contingent notes, which are for the most part linked to two assets.

“The chance of calling at point one is less than 40% here. It’s usually around or even more than 50% when you have two instead of three underlying,” she said.

“The multi-asset factor and also the fact that these ETFs are poorly correlated lower the chances of the autocall,” she added.

Take the money and run

“Since you can collect your coupon even if you’re not called, it increases the odds of earning your full coupon and getting paid longer,” she said.

This may make the product slightly more attractive for income investors but also riskier.

“In theory, anyone would want to stay all the time, get 10% a year for three and a half years,” she added.

“In reality, people are more than happy to kick out. Those autocalls are a little bit like a ‘take the money and run’ proposition. If you don’t call, your principal is at risk at maturity.”

The probability of getting paid one coupon only is 39.18%, the table showed.

“This closely matches the autocall at point one outcome,” she said.

The probability of receiving two coupons is lower at 14.49%. The probability drops to 8.03% for three coupons and to 5.37% for four coupons, which is when investors would receive their full 10% payment.

“The good news about a lower chance of calling is that you have a greater chance of being paid more. The flip side of it is that you’re running the risk of losing money at maturity,” she said.

Under the bullish scenario, the barrier will be knocked out 8.63% of the time.

“It would be lower if you had the common autocall on two indices,” she said.

“Eight point sixty-three percent may not seem like a lot. You do have quite a decent barrier at 60%.”

But the consequences of breaching are “painful.” By virtue of the point-to-point observation, hitting the barrier at maturity means a minimum loss of 40%.

“When you have a higher probability of getting through the life, it affects the chance of capital loss,” she said.

To give a broader perspective of the risk, she pointed to the probability of breaching the barrier under the bearish scenario, which would be 32.19% of the time. Even the neutral scenario shows an 18.98% probability.

Yield enhancement

“This is a higher risk product. We know it’s going to have more risk than the average worst-of on indices,” she said.

“You have a high headline rate.

“The notes are based on three underlying which are sector ETFs, not diversified benchmarks.

“There’s a low correlation between the three.

“All these factors make it less likely to call, which creates more risk.”

But assessing risk is not so easy, and that’s how stress tests can help investors when making choices between different products.

“You also have a 60% barrier, which is quite defensive. On the Russell and S&P combination it may be around 80%.”

Overall the notes share important features with their more conservative index-linked peers.

“They’re all designed for income, not to give you access to a specific market. Pricing is consistent. You may have two rather than three underlying, but your coupon and barriers will vary accordingly,” she said.

Credit Suisse Securities (USA) LLC is the agent.

The notes will settle Nov. 5.

The Cusip number is 22551N5D4.

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