Credit Suisse's ProNotes tied to index basket offer competitive principal-protection structure

By Emma Trincal

New York, Jan. 29 - A combination of longer duration, good issuer's credit and the right underlying volatility may provide investors with more competitive principal-protected notes, said structured products analyst Suzi Hampson of Future Value Consultants.

She analyzed a product that she said "would likely appeal to cautious investors seeking principal protection" but with "a good probability of attractive returns."

Hampson looked at Credit Suisse, Nassau Branch's plans to price zero-coupon principal-protected ProNotes due Aug. 27, 2015 linked to a basket of indexes.

The basket includes the S&P 500 index with a 50% weight, the Dow Jones Euro Stoxx 50 index with a 25% weight and the Nikkei 225 index with a 25% weight.

The payout at maturity will be par plus 100% to 110% of any basket gain. Investors will receive at least par.

Competitive deal

"Typically, principal-protected notes have a limited upside potential, but this product looks pretty competitive," Hampson said.

The overall rating - Future Value Consultants' score of the quality of a deal, taking into account costs, structure and risk-return profile and expressed on a scale of zero to 10 - is 7.89 for this product.

Comparatively, the risk, as measured by Riskmap - Future Value Consultants' rating of the risk associated with a product on a scale of zero to 10 - is only 1.77.

A lot of the appeal of this product, Hampson said, comes from the fact that it offers both a relatively low level of risk due to the principal protection as well as good return potential.

Risk-adjusted return

The return rating for this product is 6.65. This indicator reflects how Future Value Consultants, on a scale of zero to 10, rates the risk-adjusted return of the notes.

"That's pretty good for a principal-protected product given that we tend to be very pessimistic and conservative in our return ratings," Hampson said.

"This return rating is in part linked to the low risk. Since it's principal-protected, you're really only exposed to credit risk. And this issuer happens to have good credit. Credit Suisse's credit default swap spreads are tighter than most other issuers. So a low credit risk will reflect well in the returns," she said.

Return outcomes

In addition, the high return rating results from high probabilities of return outcomes, said Hampson, citing probability figures from her research report.

For instance, she said, the chances of earning an annualized return from 0% to 5% are 49.1%. The odds of yielding more than 15% per year are 21.2%.

"This is pretty good," she said.

Low option cost

Hampson said that the product is attractively priced and that the issuer is able to offer "fairly good terms" because "they were able to lower the cost of the option."

"Structuring a principal-protected product requires combining a zero-coupon bond that will mature at par with the purchase of a call option," she said. "The difference between the notional and the cost of the zero is what's left for the option. When rates are low, your zero coupon is going to be quite expensive. That's why they had to extend the duration to 5.5 years in order to reduce the cost of the option and be able to pay for it."

But by doing that, she added, the issuer is able to offer more attractive terms.

"You have here a participation rate of 100% to 110%. It's pretty decent. The alternative pricing method some issuers may use is to give only a 100% participation rate with a cap rather than extending the duration. It's just another way to structure a principal-protected product," she said.

One other method used by the issuer to lower its cost, Hampson said, was to choose an underlying basket that will not be excessively volatile. The historical, or underlying, volatility of the basket of indexes is only 39.50%, Hampson noted.

Volatility: balancing act

"With a principal-protected product, the more volatile the underlying, the more expensive the call," said Hampson. "So an underlying that is not too volatile helps lower the cost of the option."

However, the underlying volatility should not be too low, she said, otherwise generating good returns may become challenging.

"Here, you have an underlying volatility that is lower than other products, such as reverse convertibles' stocks. But compared to the underlying volatility of indexes used in other principal-protected products, it's fairly higher," she said.

For instance, she said that the underlying volatility of the S&P 500 index would be around 32.98%, lower than the 39.5% figure of the deal.

Better than cash

"Generally, when you evaluate a principal-protected note, you tend to compare it to cash or Treasuries given that risk is limited," said Hampson. "There is a little bit of credit risk incorporated, so it's probably not totally risk-free, but it's considered low risk. The five-year Treasury rate is now at 2.25%. It's quite low, compared to what you can earn here. So it looks like a pretty competitive product."

The notes are expected to price on Feb. 23 and settle on Feb. 26.

Credit Suisse Securities (USA) LLC is the agent.

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