Credit Suisse's covered call ETNs tied to Nasdaq Gold Flows 103 target high yield investors

By Emma Trincal

New York, Jan. 18 - Credit Suisse is planning a new gold exchange-traded note that combines a long position in the most liquid gold fund and a well-known option strategy designed to generate income, sources said, commenting on a 424B2 filing with the Securities and Exchange Commission.

Credit Suisse AG, Nassau Branch said it will price $100 million of Gold Shares covered call exchange-traded notes due Feb. 2, 2033 linked to the performance of the Credit Suisse Nasdaq Gold Flows 103 index, according to a 424B2 filing with the Securities and Exchange Commission

The Nasdaq Gold Flows 103 index measures the return of a covered call strategy on the shares of the SPDR Gold Trust, which is listed on the NYSE Arca under the symbol "GLD."

The index was created by Credit Suisse last year and is published and calculated by Nasdaq OMX.

"We have developed this index in collaboration with Credit Suisse," Dave Gedeon, managing director, Nasdaq OMX Global Indexes told Prospect News.

Chasing cash-flow

"It's a response to the appetite from the marketplace for more income-related products. People are looking for alternatives to high-yield bonds, which have seen their yields decline somewhat," he said.

With the 10-year Treasury yielding 1.90%, demand is increasingly strong for structured products delivering income, even when the coupon varies as is the case with the ETN, a structurer said.

Covered calls are option strategies designed for investors who want to generate income in a relatively stable market. The strategy, also called "overwrite" consists in holding a long position in an asset and selling call options on that same asset. The premium received for selling the calls in exchange for giving up gains beyond the strike price is what generates the monthly cash-flow.

"Structurers are talking about ways to increase yield. Overwriting is part of it...call writing...income-generating strategies. You get the premium. You're generating income. That's what it's all about," a structurer said.

The Gold FLOWS 103 index sells approximately 3% out-of-the money notional calls each month while maintaining a notional long position in GLD shares.

The level of the Nasdaq Gold Flows index on any day reflects the value of the notional long position in the SPDR Gold Trust shares and the notional option premium.

"The index is highly correlated to the GLD price," said Gedeon.

The strategy however is more sophisticated than a mere long-only exposure to the gold fund given the options overlay, sources said.

Overwriting

For one, investors receive periodic cash flow generated by the call premium. The premium also provides limited downside protection from negative market performance.

"Covered calls strategies are well known in the U.S. Investors are familiar with it. You hold Apple and you may be selling calls against your holding to generate income. People like it," a market participant said.

"Some closed-end funds have sold billions in call overwrite strategies, in which you buy the underlying and sell out-of-the money call options. It's a standard strategy, which is precisely what this index is.

"We've seen products tied to the [CBOE] S&P 500 BuyWrite Index and others similar products."

But the Credit Suisse ETNs offer something new, he noted.

"Many, many overwrite products have been done but mostly in equities. I haven't seen that type of thing with gold," he said.

What makes those overwrite strategies appealing to structured notes in general is that they can combine a long position in the underlying with the selling of calls, he noted.

With options, the seller of the call is required to sell to the buyer any upside beyond the strike price.

What happens to the index if the share price increases by more than the strike price of 103? Gedeon replied: "If the index goes above the strike, it will sell out to cover the short."

"The option gets called and it disappears. It doesn't create unlimited loss to the index. It's just a one-time event. "Next month, the index generates another option contract and the process continues.

"When the index covers a short position, the only negative is that there won't be the same participation in the upside."

The market participant explained how the price increase is not a direct loss to the investor.

"You simply don't get the extra beyond 3%," he said.

"The strike of the call is 103. If the market is up 1%, 2% or 3%, you fully benefit from it. If the price goes above the strike, for instance, it's up 5%, you're not losing any money. You're just not making the extra 2%. You've sold the right to earn more than 3%. That was your bet. Meanwhile, you're getting some income."

Total return

The return of the notes is tied to the underlying index performance. The premium provides limited downside protection, according to the prospectus. But the strategy does not offer any protection from losses resulting from a decline in the fund price beyond the notional call premium.

"The total return of the index appreciates through two components - the cash component and the share component. The first one is the option premium and the second one is the exposure to the underlying GLD," said Gedeon.

"The short call option is just one part of the strategy. The other part is the holding of the underlying index. In terms of total return, the yield by far generates the most return. The index yield last year was 14% to 15% while the price return was actually down," he said.

If the strategy generates yield, investors still need to do their due diligence, the market participant said.

"You want to know how the strategy delivers versus just holding the GLD. How much money are you generating from selling the call options?" he said.

"It will depend on a couple of factors: the strike, for instance, and the volatility necessary to generate some decent income.

"Does the income sufficiently compensate you for what you're giving up, which is any gain above 3%? That's when you need to compare the performance of this index with the return of the gold fund," he said.

For pure income seekers, the strategy poses another risk: the coupon is not fixed but varies based on the pricing of the monthly calls on GLD.

"Since the amount of any monthly coupon payment is uncertain and could be zero, investors should not expect to receive regular periodic interest payments," the prospectus said in its risk section.

Non-linearity

Andrew Lo, director of the MIT Laboratory for Financial Engineering at the Massachusetts Institute of Technology, told Prospect News that the complex strategy is not for everyone.

"Part of the risk of these types of strategies is that they're non-linear strategies. It doesn't behave like a long-only position in equity," Lo said.

"Your losses could be compounded much more quickly when the price moves against you. The typical investor may not understand this type of relationship or fully understand the nature of the risk generated by the optionality and the implicit leverage.

"It's definitely more appropriate for institutional investors, high-net-worth and family offices that have the capability of understanding the risk reward and who can manage the risk on a real-time basis.

"The real-time risk can change much more because of the macro uncertainties hanging over the market.

"The debt ceiling for instance can cause a pretty sharp reversal especially with instruments like gold and Treasuries used in flight-to-quality.

"While those securities can play an important role in the market and while institutional investors can make a good use of them for hedging, for instance, the retail investor has to be careful because of the exotic risk-reward profile," he said.

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%.

The initial tranche of notes is expected to price on Jan. 28 and settle on Jan. 31.

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

The Cusip number is 22542D480.

The investor fee is 0.65% per year.

Credit Suisse Securities (USA) LLC is the agent.

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