HSBC's twin participation notes tied to S&P 500 offer unusual payout, possible absolute return

By Emma Trincal

New York, Oct. 31 - HSBC USA Inc.'s 18-month 0% twin participation notes due May 14, 2013 linked to the S&P 500 index offer an unusual payoff with absolute returns for investors who expect the underlying index to trade in a range with a slightly bearish bias, financial advisers said.

"I'm totally intrigued by it. I've never seen a structure like that," said Carl Kunhardt, wealth adviser with Quest Capital Management, commenting on the notes' ability to generate a gain even if the index declines as long as a trigger event fails to occur.

A trigger event occurs if the index closes below 65% of the initial level on any day during the life of the notes, including at maturity, according to an FWP filing with the Securities and Exchange Commission.

If a trigger event has not occurred and the final index level is greater than the initial level, the payout at maturity will equal par plus the index gain, subject to a maximum return of 17% to 22%. The exact cap will be set at pricing.

If a trigger event has not occurred but the final level is less than or equal to the initial level, the payout at maturity will be par plus the absolute value of the index return.

If a trigger event has occurred, investors will receive par plus the lesser of the index return and the cap.

"The best scenario is if it goes down and floats around 35%. That's what's so incredible," said Kunhardt.

He said that an investor would make more money if the index finished down 30% than if it closed up 30% because of the absolute return gains on the downside and the 20% cap on the upside, assuming the 65% barrier would not be breached during the period.

"It's a little bit of a bearish play with a hedge," said Kunhardt.

"You want it to go down but not down below the 35% and you still make money up to the cap if it goes up," he said.

Outperforming the index

Kunhardt said the notes were likely to outperform a direct buy-and-hold investment in the S&P 500.

The worst-case scenario can only happen if the index falls below the trigger level. As a result, the main risk is illiquidity - or being locked into the notes if the event was to happen.

"The trigger can happen at any time. Just one day and that kills it," he said.

The occurrence of the trigger event could result in two problems, he noted.

First, investors would lose the principal protection advantage and any index decline at maturity would then count as a loss from the initial index level.

Second, investors would lose the benefit of the absolute returns.

"Absent a trigger event, the worse thing that can happen is that I get my money back," he said.

"If the trigger happens, you are a little bit worse off than being long the index because if I own the index, I can stop bleeding. I stop the security, while with this note I'm there for 18 months.

"This liquidity risk is probably the reason why I would not recommend this product to my conservative investors or to the elderly client."

35% drop

But Kunhardt said that he would probably advise his more risk-tolerant clients to invest in the note as a small portion of their portfolio within an alternative investment bucket.

Based on historical data, the S&P 500 has rarely dropped by 35% or more during an 18-month period, he said, which is why he felt comfortable with the downside risk.

"The index fell 37.5% in 2008, but that was in one year," he said.

The S&P 500 declined by 56% from its high in October 2007 to its low in March 2009, and it fell by more than 35% between March 2000 and September 2001.

"That's the exception, not the norm," he said.

"You kind of roll the dice a little bit if we breach that 35% down. But the odds are limited, and you can make money in a down market.

"This is a note that I like, although it's not the type of thing I usually recommend.

"But with my most aggressive clients, I might try it. I might just try it for myself as well.

"For a client with a moderate risk profile and who is young, I might recommend it as well as a small piece."

For Michael Kalscheur, financial adviser with Castle Wealth Advisors, the notes could easily outperform other structured products of the same duration because of the benefit provided by the absolute return payout when the index declines.

Not so risky

"This is for someone who has a trading range outlook," he said.

"I've seen a couple of those absolute return notes. I don't know how they put these kinds of deals together. I'm sure by using puts and calls they can make it work that way."

Looking at reducing risk, according to his methodology, Kalscheur said that two factors appeal to him: the term and the issuer.

"Eighteen month is short in a way, which is probably good. You want your money tied up for a period as short as possible," he said.

"And as of credit risk, it's HSBC. They're rock solid. Credit risk is not an issue here."

The odds of generating a profit are satisfying as well, he said, given the expected range.

"You're anticipating that the index will be in a minus 35% [to] 20% plus range 18 months from now," he said.

"Statistically speaking, it will probably be on that range more than 50% of the time."

One risk on the upside is to stop participating in any appreciation of the index above the cap.

"But you don't get hurt. You just miss the upside potential," he said.

"What the market is as of today, at which level it prices out will make a big difference."

Better than average

Assuming that the cap is 20%, Kalscheur said that the notes "compare well" with other products of the same maturity.

"A typical 18-month on the S&P 500 will give you a 10% buffer with the same type of cap at 20%," he said.

"Would I do this structure versus the usual type? I think so.

"With this, at least I get a 35% downside protection and if the index is down 20%, I'm actually up 20% versus down 10%."

When compared to a buy-and-hold investment, the notes offer the same risk profile.

"If the index is down 50% and you lose 50%, you'd be down 50% with the index anyway," he added.

"If you think the market is going to trade range bound between minus 35% and plus 20%, that's not a bad thing to roll the dice on with a small portion of the portfolio depending on how much the fee is.

"The liquidity risk is the only big issue, but again it's only 18 months.

"It's a compelling story."

Near the end of the day on Monday, the issuer changed the trigger level to 70% of the initial index level and the expected maximum return to a range of 18% to 22%.

The notes (Cusip: 4042K1RD7) will price on Nov. 9 and settle on Nov. 15. They were originally expected to price Friday and settle Nov. 9.

HSBC Securities (USA) Inc. is the agent.

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