Credit Suisse's digital-plus notes linked to S&P offer good features but on a longer tenor

By Emma Trincal

New York, April 24 - Credit Suisse AG's 0% digital-plus barrier notes due May 31, 2019 linked to the S&P 500 index combine attractive features such as return enhancement delivered via a digital payout, a barrier observed at maturity and uncapped upside, but the trade-off is a longer maturity, sources said, expressing various reactions to the extended duration as a condition for better terms in an offering.

If the final index level is greater than or equal to the initial index level, the payout at maturity will be par plus the greater of the fixed payment percentage and the index return, according to a 424B2 filing with the Securities and Exchange Commission.

The fixed payment percentage is expected to be 27.5% to 32.5%. Sources assumed the mid-point of 30%, which is also used in the hypothetical redemption amounts table in the prospectus.

On the downside, if the final index level is greater than the knock-in level, expected to be 70% of the initial index level, but less than the initial level, the payout will be par.

If the final index level is less than or equal to the knock-in level, investors will be fully exposed to the index decline from the initial level.

The exact terms will be set at pricing.

Basic and attractive

For Matt Medeiros, president of the Institute for Wealth Management, the five-year length is acceptable given the terms and the notes' underlying.

"It's a pretty basic structure. It's interesting," he said.

"We like the S&P going forward. Having an enhanced return if the performance of the S&P is moderate is very attractive. Also, the no cap is definitely a plus.

"The 30% barrier on the downside is a very generous amount of protection for this underlying asset class.

"Finally, the five-year [term] for the S&P is a fair holding period. So I think that overall, it's a pretty good offering."

Tolerable risk

A longer-dated product may represent a greater risk in two scenarios, he said: if the issuer's credit is "questionable" and if the product is not "marketable."

"When you are looking at a five-year product, you have to look at credit risk, obviously," he said.

"As long as the issuer's credit is good, it doesn't seem to be too much of a concern. You certainly don't want to pay a premium for something that has a questionable credit, but Credit Suisse is beyond questionable."

The underlying used in the notes also has an impact on the risk.

"If you have a structure that's not very marketable for a number of reasons, for instance if it's an esoteric asset class or strategy, you would have to look at the credit risk perhaps even more," he said.

"Assuming that a credit event occurs and that the issuer needs to resell it to another firm, it's much easier to do that with a marketable note, and an S&P-based product is going to be more marketable than something linked to an esoteric asset class. The simplicity of the structure and strategy, the liquidity of the underlying reduce the risk associated with a liquidity call.

"I don't have an issue with the five-year term. We have an optimistic mid-term outlook for the S&P. We're not expecting the returns of 2013, but we are seeing nice, consistent returns in the higher single digits."

Steven Foldes, president of Foldes Financial Management LLC, said that he prefers to keep the notes he buys for his clients short in duration.

"I like the structure, but I don't like that it's a five-year," Foldes said.

Nice conceptually

"Conceptually, I like the idea of a downside protection with a 30% barrier point to point," he said.

"If the index goes down 50% during the course of the deal and then goes back up to close down 29%, you're still protected.

"The fact that you have a guaranteed 30% over the initial price is also a nice feature. It's shy of 4% or 5% on a compounded basis, plus you get the full extent of the upside.

"The problem is the five-year term. It goes beyond the threshold of what we feel comfortable with.

"We like the uncapped upside. We like the S&P. But we don't like this underlying extended to that period of time. That for us is the real negative."

Dividends

The longer maturity is not just a problem in terms of how hazardous it is to predict the market five years from now, he explained. It also involves credit risk and liquidity risk. And in the case of the S&P, which offers a 1.85% dividend, the loss of dividends over a long period of time represents a disadvantage for the noteholder compared to investors long the index.

"If you take into account the dividend yield, the compounding and the reinvestment of dividends, foregoing this additional source of return over a long period of time represents a high opportunity cost for the investor," he said.

"We like the deal conceptually. It's just too long for us."

Tough pricing environment

"If I was doing this deal for our firm, I would try to see if I can get the number of years down to two or maybe three years. But I'm not optimistic," he said.

"We have tried recently to negotiate the terms of a four-year note that we liked. We wanted it to be a two- or three-year product, and we went nowhere.

"So I am speculating that shortening the duration on this deal would make the pricing unattractive as well. It's just the way the market is right now.

"Our experience has been that the nice features of a note, such as the level of downside protection, the amount of guaranteed return or the uncapped upside, turn into substantially less attractive terms as soon as you shorten the maturity, making at the end the note unappealing.

"Of course if I could get a 20% barrier over two years, a 20% guaranteed return with an uncapped outside, that would be fantastic. But how likely is it to happen? It's more likely that the issuer would restructure the product in such a way that we would have to take a pass on it."

Credit Suisse Securities (USA) LLC is the agent.

The notes will price May 23 and settle June 2.

The Cusip number is 22547QMM5.

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