Credit Suisse's notes linked to CS Merger Arbitrage Liquid offer protection, uncapped upside

By Emma Trincal

New York, May 3 - Credit Suisse AG, Nassau Branch's upcoming 0% CS notes due May 31, 2016 linked to the Credit Suisse Merger Arbitrage Liquid Risk Controlled index offer unlimited upside with principal protection to investors seeking exposure to merger arbitrage, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 1.3 to 1.4 times any index gain. The exact participation rate will be set at pricing.

If the index falls, the payout will be par.

The Credit Suisse Merger Arbitrage Liquid Risk Controlled index is based on the Credit Suisse Merger Arbitrage Liquid Index (Excess Net), an index that gives investors exposure to merger arbitrage returns. The strategy is designed to capture the spread between the stocks of the two merging companies.

"The principal protection makes this more attractive," said Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management.

"You have leverage on the upside with no cap, which is attractive as well."

Base index

The base index uses a quantitative methodology to track a dynamic basket of securities. The index components consist of long positions in target stocks and short positions in the acquiring company's stock. Typically, the stock of a target company will rise after a merger is announced while the share price of the acquiring company will tend to decline after the announcement.

"As long as you keep discussions on arbitrage simple without going into too much detail, it can be explained. We have clients who are interested in these types of investments. If you believe in arbitrage strategies or M&A types of plays, it's a good way to do it because you have the principal protection," Wright said.

Volatility target

The Credit Suisse Merger Arbitrage Liquid Risk Controlled index introduces a volatility element, according to the prospectus. The volatility target is 5%.

"There is a volatility component in this index," said a volatility arbitrage hedge fund manager. "It allows you to control risk."

Each month, the exposure to the index is dynamically reset to adjust to the 5% volatility target, according to the prospectus.

"This target makes for a pretty conservative strategy," the hedge fund manager said.

While the volatility of the Merger Fund, a mutual fund often used as a benchmark, is only 2%, merger arbitrage strategies can be extremely risky in a down market, he said.

For instance, volatility for merger arbitrage in the midst of the financial crisis in 2008 spiked at 52%, he noted.

"This is why this product is pretty conservative. You avoid that spike of volatility you can get in a bear market."

Strategy versus index

Tom Burnett, director of research at Wall Street Access, said that investors using synthetic indexes to play merger arbitrage may be missing out on returns.

"I don't know how you can get the flexibility and the liquidity to get in and out of positions quickly when you use a rules-based index," he said.

"With merger arbitrage, you have news every day. Spreads widen, they get narrow, they change. You're missing out on volatility and returns when you can't get in when spreads widen and out when they tighten. This strategy locks you in."

Popular underlying

Credit Suisse has used its proprietary Merger Arbitrage Liquid index before as well as the Merger Arbitrage Liquid Risk Controlled index.

For instance, Credit Suisse priced $58.64 million of 0% exchange-traded notes due Oct. 6, 2020 linked to the Credit Suisse Merger Arbitrage Liquid Index (Net).

In March, the firm announced the launch of its 2x Monthly Leveraged Credit Suisse Merger Arbitrage Liquid Index (Net) ETNs.

"Notes tied to this index, including the one with the volatility component, have been offered before with the private banks," a market participant said.

"It's been offered in a bunch of different ways and to different investors. It's been done with capital-at-risk structures and also principal protected," he said.

The latest notes (Cusip: 22546E6C3) will price on May 25 and settle on May 31.

Credit Suisse Securities (USA) LLC is the underwriter.

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