Credit Suisse's covered call ETNs tied to Nasdaq Silver Flows 106 index seen as complex, risky

By Emma Trincal

New York, April 8 - Credit Suisse AG, Nassau Branch's planned $100 million of Silver Shares covered call exchange-traded notes due April 21, 2033 linked to the Credit Suisse Nasdaq Silver Flows 106 index are designed to generate income via the underlying covered call writing strategy while providing limited upside participation in the iShares Silver Trust, according to a 424B2 filing with the Securities and Exchange Commission.

While the periodic cash flows may be appealing to income-seeking investors, financial advisers said they were not comfortable with the complexity of the notes. In addition, they pointed to the risk versus reward of a product that features a capped upside with full downside risk as well as variable, not-guaranteed coupon payments.

The underlying index is built around a "covered call." This income-producing option strategy consists of selling call options against shares of stock already owned. For writing the calls, the investors earn a premium.

The Nasdaq Silver Flows 106 index measures the return of a covered call strategy on the shares of the iShares Silver Trust (SLV), according to the prospectus. In this hypothetical portfolio, the index takes a long position in the SLV shares and sells a succession of short, about one-month, call options on the shares with a strike price of about 106. The sale of the options is "covered" by the long position in the SLV. The long position in the shares and the short call options are held in equal notional amounts.

Investors collect a variable monthly coupon from the premium received, which can also be used to offset some of the losses caused by downside market performance. Additionally, the index offers limited upside participation in the shares, according to the prospectus.

For each ETN, investors will receive a cash payment at maturity, or payment upon early redemption or acceleration, that will be linked to the performance of the index less a daily investor fee. If the index declines, investors can lose up to 100% of their investment, the prospectus warned in the risk section. As with any notes, investors are also subject to the issuer's credit risk.

Keep it simple

Carl Kunhardt, wealth adviser at Quest Capital Management, said that the "complicated" product was a negative for financial advisers such as himself seeking to offer simple, easy-to-understand products to their clients. In addition, complexity carried a cost, he noted.

"An excellent strategy for any adviser is to keep it simple," he said.

"I would never sit down and talk to clients about this. It's just too complicated. If I have to stumble over it, I won't have that discussion with the client."

The covered call strategy is rolled from a month to the next, according to the prospectus. At each roll date, the index notionally sells the new option and closes out the previous short call position. The shares of the silver fund are used to notionally repurchase the call.

Sources familiar with BuyWrite indexes said that most of the return is made through the cash flow earned from the premium. According to the prospectus, the upside participation is indeed limited by the fees and expenses applied to the silver fund shares as well as the design of the index methodology.

Alternatives

"Covered calls are a known strategy, but not everyone does it or understands it. The average investor doesn't do it. If you wanted to do it, there are far easier and, frankly, less risky ways to do it," Kunhardt said.

"For instance, you could buy a portfolio of stocks - General Electric, Microsoft, whatever you'd like - and then write covered calls on those positions.

"Any time a product, regardless of the structure, tries to do too much, something ends up blowing up in your face.

"If you want to play long/short, fine; it's your game, but ignore everything else.

"If you want to write covered calls, that's fine too. Just do that.

"You should either be an investor or a trader, not both. This note is trying to do both. And that's the problem right there.

"Trading to me is a fool's game. But there are people who think it's the way. Fine. Do what you're good at.

"This product is trying to do two or three things at the same time: creating a long exposure with covered calls; generating higher yield; and having a separate correlation from the other asset classes within the portfolio.

"I think you can better implement the strategy if you do the two or three things separately."

The notes are putable at any time subject to a redemption fee. Kunhardt said that he would prefer the liquidity of a mutual fund over that of an ETN.

"If I wanted to have someone implement a BuyWrite strategy for me, I would choose a mutual fund over an ETN," he said.

"Some mutual funds would do just that, for instance the PowerShares S&P500 BuyWrite Portfolio ETF.

"The ETN doesn't have the same liquidity as a mutual fund. It's one of those issues with ETNs as opposed to ETFs.

"The credit issue is the other piece. If an issuer goes broke, they obviously won't buy back your note. It's unsecured debt, and you're a creditor. It's just an IOU.

"The mutual fund has daily NAV. Here you have to put the notes back to the issuer. You have these complicated calculations, and the liquidity is not guaranteed."

According to the risk section of the prospectus, the issuer is not obligated to sell additional ETNs and may suspend issuance of new ETNs, which could adversely affect the price and liquidity of the notes.

Call risk, downside exposure

Scott Cramer, president of Cramer & Rauchegger, Inc., agreed about the credit and liquidity risk but said that his main concern was the downside risk.

"This is an income-generation strategy. You're getting potential income. But you don't have the downside protection really. It doesn't seem like something I would like to do," he said.

"When you do things you don't manage every day, when you enable the manager - in this case, a proprietary index - to make the decisions for you and you don't really understand what you're doing, you're taking a whole bunch of risk."

The issuer can call the notes at any time, according to the prospectus. In addition, the notes are automatically called if the intraday indicative value of the ETNs falls below 5%.

"That's another risk: The notes could get called out from under you," he said.

"At first it looks simple enough: We're long the silver fund, and we're doing call writing, and these are covered calls. But we still have the market risk.

"The best thing that could happen to you is that the price stays the same. Then the call would never be exercised.

"When you're writing calls, you give somebody the ability to call the stock from you. If you think something is going up, you shouldn't use this strategy. You would lose in potential appreciation. That's a risk. You're not going to get anything above 6%.

"You have the limited upside which is part of the call-writing strategy, and you have no downside protection.

"It's the lack of downside protection that I particularly don't like."

Putable, callable

The current principal amount is $20.00 on the inception date, according to the prospectus. After that, the current principal amount is the current principal amount on the preceding day times the daily index factor minus the daily investor fee. The investor fee is 0.65% per year.

The daily index factor is the closing level of the index on that day divided by the closing level of the index on the preceding day.

The notes are callable in whole or in part at any time and are putable subject to a minimum of 50,000 ETNs and an early redemption charge of 0.125%.

The notes will be automatically called if the intraday indicative value of the ETNs falls below 5%.

Credit Suisse has applied to list the ETNs on Nasdaq under the ticker symbol "SLVO."

Credit Suisse Securities (USA) LLC is the agent.

The notes will price on April 16 and settle on April 19.

The Cusip number is 22542DFC9.

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