Credit Suisse, Morgan Stanley plan notes with barriers; volatility considerations peculiar, analyst says

By Kenneth Lim

Boston, Oct. 31 - Credit Suisse's planned callable yield notes linked to three stock indexes are highly risky and work best if underlying volatility stays within a range, structured products analyst Suzi Hampson of Future Value Consultants said.

Meanwhile, equity-linked straddle notes are coming with wider ranges in response to the higher volatility of stocks, she said.

Credit Suisse links to indexes

Credit Suisse, acting through its Nassau Branch, plans to price 18.5% callable yield notes due Nov. 27, 2009 linked to the S&P 500, Russell 2000 and Dow Jones Euro Stoxx 50 indexes.

The notes will pay interest quarterly unless called by the issuer.

If any of the underlying indexes closes at 60% or below of its initial level during the life of the notes and any of the indexes finishes below its initial level, investors at maturity will lose 1% of their principal for every 1% that the worst performing index declines below its initial level. Otherwise investors will receive par at maturity.

Risky notes

The Credit Suisse notes fall on the riskier end of the structured products spectrum, Hampson said.

"I'd say it's probably considerable risk," she said.

The high risk profile of the notes is due to the link to the worst performer among the underlying indexes. The more underlying indexes there are, the riskier the product becomes, she added.

Linking the product to indexes instead of individual stocks could help to reduce some of the risk, because indexes tend to be less volatile than stocks, Hampson said.

"You're getting an extra 15% above the risk free rate, which is about 3%, and that must be made possible by taking some risk to the capital, and it's a high coupon," she said.

"They're basically worst-of reverse convertibles but they've added a twist," she said. "They've added a call to the notes."

Call adds twist

The call feature does not affect the risk rating of the product by much, because the notes are likely to be called only if they are in the money, but it lowers the price of offering the notes, which means that Credit Suisse can "offer a higher coupon by adding in that callable part," Hampson said.

The call suggests that the issuer will redeem the notes early if all three indexes are up when the quarterly interest payment dates arrive, because doing so can save the issuer on future interest payments, Hampson said.

"It looks like when the product is going to perform at its maximum, which is when the indices are way up, that's when the issuer will call the notes," she said. "Which will not exactly be a loss for the investor, but it would not be what the investor would want at that time."

But if the barrier is broken, the issuer is unlikely to call the notes, Hampson added. The best case for investors is therefore if the volatility of the underlying indexes remains within a certain range, she said.

Straddle ranges widen

Hampson also noted that barrier ranges have widened in straddle notes linked to the S&P 500 index.

One example is Morgan Stanley's zero-coupon principal protected absolute return barrier notes due May 20, 2010 linked to the S&P 500.

At maturity, investors will receive par plus the absolute index return as long as the index remains within a lower boundary of 69% to 71% of the initial level and an upper boundary of 129% to 131% of the initial level during the life of the notes. The exact range will be set at pricing. If the index moves outside of the range during the life of the notes, investors will receive par.

"You'd expect a wider range [now] because volatility has gone up so much," Hampson said. "The chance of breaching the barrier is higher."

Investors who think that the equity market is going to be volatile may consider such a product, she added.

"For investors who thought that it would be one of the most volatile times in the S&P in the next one or one and a half years, it might be one of the better times to get in now," she said. "If the index is the same a year from now, you get nothing, and you get more if the index changes more."

She said both the Credit Suisse and the Morgan Stanley notes highlight a peculiar trait of barriers.

"A contradictory aspect of barriers is you want the underlying to be volatile, but not too volatile," she said.

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