Credit Suisse's buffered leveraged notes linked to MSCI EM fund aimed at conservative bulls

By Emma Trincal

New York, Feb. 21 - Credit Suisse AG, Nassau Branch's 0% buffered enhanced participation equity securities linked to the iShares MSCI Emerging Markets index fund are designed for cautious bulls and would not be a good fit for aggressive investors given the cap, sources said.

The notes will mature 23 to 25 months after pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 130% of any index gain, up to an underlying return cap of 18% to 22%.

Investors will receive par if the index falls by up to 17.5% and will lose 1.212121% for each 1% drop beyond 17.5%.

Sources chose the hypothetical and mid-range values of a two-year duration and a 20% cap.

Based on these assumed terms, the annualized maximum return would be 10%, which could be achieved after leverage with a 7.7% annual growth in the fund.

Upside risk

Kirk Chisholm, principal and wealth manager at NUA Advisors, who is selectively bullish on emerging markets, said he would not consider the notes for several reasons. His main one was the cap.

"With the money printing going on globally, emerging markets have a lot of upside potential right now. I personally don't like the cap," he said.

"In times of markets going up globally, emerging markets tend to perform better. On the other hand, when times are bad, they underperform. There's more acceleration behind emerging markets returns.

"If you're bullish on emerging markets, you're not going to be satisfied with a 10% cap. However, the fact that it has a buffer helps offset that problem, at least for some investors but not for us. For us, the appeal of emerging markets is the upside."

Broad index

Chisholm added that the underlying fund may not be his first choice for exposure to the asset class because he prefers to be selective on the countries he wants to invest in.

China, South Korea, Brazil and Taiwan make for more than half of the iShares MSCI Emerging Markets fund.

"We like certain emerging markets right now. We don't do the broad spectrum. We'd rather look for fine-tuned investments," he said.

For instance, Chisholm said that he was bullish on Hong Kong.

"Their currency is pegged to the dollar and as a result, our money-printing policy here in the U.S. ends up pushing up stock prices over there. It creates asset inflation," he said.

"On the other hand, I would not invest in Brazil, Russia or South Africa, which are important components of the index."

At 12.46%, Brazil has the third-largest weight in the MSCI Emerging Markets index, which the fund replicates. South Africa and Russia account for 7.24% and 6.13% of the index, respectively.

"At the same time, some emerging markets that we like, such as India, Indonesia or Turkey, may not constitute the largest weightings."

Right timing

There is also a problem with the duration of the trade, Chisholm said.

While 24 months is not considered long term in structured investing, the use of a volatile ETF as the underlying may make the risk particularly sensitive to the length of the product, he said.

"During the right times, investing in emerging markets can produce tremendous results. Recently, many countries have joined the fray in money printing. Reflation policies are being implemented by diverse governments all across the world simultaneously. Under those conditions, we think emerging markets will do well," he said.

"Right now, at least until the end of the year, we expect a continuation of the money printing trend. But this is a two-year note. Who is to say that the same conditions will apply a year from now?

"Emerging markets can turn on a dime, and during bad times, they can generate horrendous returns."

Chisholm said that timing was an essential aspect of emerging market investing.

"Emerging markets, unlike the S&P 500, is not a buy-and-hold strategy. You buy at the right time. You hold until the conditions change. Then you get out. You have to understand what you're doing.

"That's why I don't like the idea of locking in out for two years. If we had another 2008, I wouldn't want to be locked in in these notes," he said.

The strategy used in the notes works best for the S&P, or a less volatile underlying, he said, because it makes more sense in those cases to be slightly bullish, neutral or even slightly bearish.

"This note is replicating a covered call writing strategy. You buy a call, you sell a put and you're putting it into a note. These are excellent risk-return strategies for something like the S&P 500. In my opinion, it's not appropriate for emerging markets, where what you want is high returns," he said.

Conservative play

Tom Balcom, founder of 1650 Wealth Management, said that the notes were not for everyone and certainly not for investors who expect strong gains in emerging markets.

"If you're bullish, if you're optimistic about emerging markets, obviously it would not make sense to cap your upside," Balcom said.

"But if the client is risk averse, if they'd rather have the downside protection first, getting a 10% potential return for the next two years is not such a bad deal.

"It depends on the investor.

"Most of my clients are more fearful than greedy. For them, the reasoning is let's have downside protection first. Protect the investment first and foremost.

"For someone who wants exposure to emerging markets but who needs to play defense first, getting a 17.5% downside protection with a 10% potential annualized return is not a bad trade-off.

"We have conservative clients who would find that risk reward appropriate."

Geared downside

The downside protection features a 1.2121% downside leverage factor applied to all losses in excess of the 17.5% buffer amount.

For instance, a 25% final fund decline would represent a 9% loss of principal for the noteholder. A 60% decline would generate a 51.52% loss of principal.

If the 17.5% was a regular buffer without downside leverage, a 25% fund decline would have created a 7.5% loss instead of 9%.

For Balcom, the sizeable buffer more than offset the disadvantages of the downside leverage.

"Yes, it's a geared buffer. But you probably would've had only 10% on an ungeared buffer," he said.

"The leverage on the downside can be a problem, but it really starts to have an impact when losses are huge.

"Losing 9% out of a 25% decline is not much. In fact, most clients would be happy with that. You're still better off with this than being long the ETF.

"The leverage on the downside will multiply your losses when the decline is substantial. But when it is a big decline, you lose a lot either way."

For instance, a 60% fund decline would have caused a 42.5% loss of principal with a traditional 17.5% non-leveraged buffer versus a 51.52% loss with the buffer used in the notes.

"It doesn't make much difference: when you're crushed, you're crushed," he said.

The notes (Cusip: 22546TZ95) will price and settle in February.

Credit Suisse Securities (USA) LLC is the agent.

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