Credit Suisse's 2x monthly leveraged ETNs tied to Merger Arbitrage designed to boost returns

By Emma Trincal

New York, March 10 - A new exchange-traded note offering leveraged exposure to the merger arbitrage strategy is seen as a way to enhance returns for a strategy with low volatility, which could benefit investors seeking to boost returns, a market participant said.

New product

Credit Suisse AG, Nassau Branch priced $15 million of 0% ETNs due March 13, 2031 linked on a leveraged basis to the Credit Suisse Merger Arbitrage Liquid Index (Net), according to a 424B2 filing with the Securities and Exchange Commission. The notes are listed on NYSE Arca under the symbol "CSMB."

The company plans to issue up to $250 million of the notes. The initial $15 million of notes priced at par of $20, and the remainder of the notes will be sold from time to time at variable prices.

This new ETN follows the launch in October of a non-leveraged ETN tied to the same index and trading under the NYSE Arca symbol "CSMA." The company had planned to issue up to $1 billion of the non-leveraged initial version. The bank so far has sold $66.38 million of those notes.

The new ETN - as its prior unleveraged version - is tied to an index that replicates merger arbitrage. This strategy takes advantage of price differences that occur in merger deals. The index typically buys the securities of the target company and shorts the securities of the acquirer. The strategy is historically market neutral, according to Credit Suisse's performance brochure for its index. But risk does exist, as stated by the brochure. It warned, "The strategy takes on the risk that a deal may fall through."

The net annualized rate of return based on hypothetical performance data from January 1998 to December 2009 and actual performance data from January 2010 to January 2011 is 6.37%, according to the brochure. Volatility was about 4.8%.

Enhancing returns

"The notes target mainly institutional investors," the market participant said. "The strategy itself is very low vol. As a result, a lot of people were looking for ways to amplify the returns."

Adding leverage to enhance returns may be necessary for some investors, but the investment also becomes much more risky, a merger arbitrage analyst said.

"I think the unleveraged strategy can't make any money, so it makes sense to add leverage," this analyst said.

"The problem right now is that the spreads in merger arbitrage are pretty tight. When spreads are tight, there's always the risk that they could widen. It's what happened last year with the flash crash. Spreads moved from 5% to 7%.

"The volatility of this strategy may be low, but you can get those big market dislocations.

"A two times leverage is a reasonable level, but it's still very risky. For instance, a 20% loss on a stock with a 5% exposure and a leverage factor of two will generate a 2% loss in your portfolio."

Inherent leverage

Tom Burnett, director of research at Wall Street Access, said that he was skeptical about the product because the underlying index strategy did not reflect a pure arbitrage play. It merely sought to mimic the performance of the strategy in using long and short positions.

"I doubt that they could attract a lot of capital," he said.

"Most merger arbitrage players go by the individual risk profile of each deal. It's a pretty unique, arcane strategy. If the spread widens, you add to it. If it narrows, you take them off," he said.

"With the index, it's a lock-in strategy. There's nothing that says trade out of it if the spread narrows."

In addition, Burnett said that a leveraged version of the notes created too much risk for investors as the underlying strategy itself already employs a fair amount of leverage.

"Merger arbitrage is already a leveraged trade. It's always three or four to one against you. One point up and I can lose four if the deal doesn't go through," he said.

He offered the following example: "A stock trades at $15, and the next day an offer is made to acquire the company at $20. The stock moves up to $19. You make one buck if you buy it there. Or you can lose four if the deal doesn't go through.

"You already have plenty of negative leverage in the strategy itself. You don't need to add more.

"Most deals go through, but some do get called off. The leverage makes your potential losses much worse."

Credit Suisse Securities (USA) LLC is the agent.

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