Credit Suisse’s notes on Core S&P Small-Cap ETF may beat fund return, but credit risk too high

By Emma Trincal

New York, Dec. 20 – Credit Suisse AG, London Branch’s buffered accelerated return equity securities due June 30, 2025 linked to the iShares Core S&P Small-Cap ETF could outperform the underlying fund, a financial adviser said. But for another, the high credit risk as measured by the bank’s credit default swaps is a deal breaker.

If the ETF return is positive, the payout at maturity will be par plus 125.65% of the ETF return, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the ETF return is flat or falls by 10% or less and will lose 1% for every 1% decline beyond 10%.

Equity replacement

Carl Kunhardt, wealth adviser at Quest Capital Management, said the notes represent an attractive equity substitute in a portfolio despite a weak downside protection.

“The 10% buffer is not enough for small caps. If there is a sell-off, 10% is not going to do much of anything.

“And yet, I would do it simply because small-caps are going to have to be in your portfolio anyway,” he said.

In assessing the notes, he said, investors have to ask themselves whether it’s better to hold the notes or to be long the underlier. In this case, the note was more advantageous.

“On the upside, it gives me the opportunity to do better than the ETF whatever the ETF does because of the uncapped leveraged exposure,” he said.

“I’m giving up the dividends, true...but small-caps are not going to pay much dividends,” he said.

On the downside, the buffer allowed investors to outperform as well.

“I’m better off holding my position with the note than with the ETF – on both sides of the ledger.”

Russell vs. S&P

One particularity of the note was the choice of the underlying ETF as a proxy for the asset class. The most commonly used underlier for small-cap exposure is the Russell 2000 index or its ETF equivalent, he noted.

“It’s a little bit different here. You just have fewer holdings,” he said.

The Russell indices tend to have a wider breadth than their S&P counterparts, he explained.

The iShares Core S&P Small-Cap ETF tracks the S&P SmallCap 600 index and has 675 holdings versus the 2,000 components of the Russell 2000 index.

“But it doesn’t make a big difference because both the Russell 2000 and the S&P SmallCap 600 are cap-weighted. Small percentage differences will not move the needle,” he said.

Bouncing back

The notes would be a good fit for investors who want to play a market rebound, he said, as small-cap stocks tend to outperform in a market coming out of a recession.

“Since October, the market has been on an upswing. If we are at the beginning of a recovery, small-caps should show stronger returns,” he said.

The notes given their uncapped leveraged upside have been designed for bullish investors, which may explain the “skinny” buffer.

“The buffer size is a bit skinny. That would be my only concern. But better have a 10% buffer than no protection. I would still do the notes because you’re better off with it anyway,” he said.

Sky-high CDS

Steven Foldes, wealth manager and founder at Evensky & Katz / Foldes Financial Wealth Management, expressed concerns about the credit risk exposure.

“When you’re buying a structured note, you want to make sure the issuing institution is around to pay you at maturity. We all remember the 2008 financial crisis, which forced the government to intervene,” he said.

Credit Suisse has been hit by several setbacks over the past few years, including losses associated with the implosion of hedge fund Archegos Capital Management in 2021. The Swiss bank’s wealth management business has also incurred significant levels of client asset outflows in October and November, according to Morningstar analyst Johann Scholtz. The bank right now is in the process of raising capital.

“The situation at Credit Suisse is concerning. This issuer is under a lot of pressure as reflected by its CDS spreads compared to other banks,” said Foldes.

Credit Suisse’s five-year credit default swaps are at 396 basis points, according to S&P Global Market Intelligence. In comparison, UBS’ swaps are quoted at 80 bps. In the United States, Goldman Sachs carries the widest spreads at 103 bps and JPMorgan, the tightest at 81 bps.

“I don’t think I’ve ever seen swap rates as wide as 396 bps. That means the cost of insuring their debt is extremely high. That’s a real red flag,” said Foldes.

Buffer, length

Yet for the most part, he liked the terms of the notes.

“It’s a two-and-a-half tenor. We would prefer a two year, but it’s still relatively short,” he said.

“The small cap universe is something we’ve written notes on in the past. We like the diversification of the underlying.

“Having uncapped upside is always attractive.”

However, the cost of structuring a buffer would have been better spent elsewhere, he said.

“We don’t believe that having a 10% buffer is necessary. You’re buying today at about a 20% discount. If you look at historical performance, it’s unlikely that two-and-a-half years from now, the index will finish negative,” he said.

Foldes, if he decided to consider the notes, would change some aspects of the structure.

“I would check with the issuer to see what type of leverage we could get if we eliminated the buffer. That would be the first thing. The second thing would be to get a quote on what we get if we shortened the term, making it a two-year. Even with a shorter note, we would still get rid of the buffer,” he said.

But Foldes would probably seek a different issuer.

“We like the note, and we may compare it with other issuers. These are the kinds of terms we would like in general. But you have to make sure the issuer has a good credit quality, which is not the case here,” he said.

“The ability of the issuer to repay is critical. The credit quality is in doubt here. So, unfortunately, it would be a non-starter for us,” he said.

Credit Suisse Securities (USA) LLC is the agent.

The notes will price on Thursday and will settle on Dec. 28.

The Cusip number is 22553QPL5.

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