HSBC's coupon-bearing notes linked to Ford are designed for yield-seekers, not for bulls

By Emma Trincal

New York, Nov. 20 - HSBC USA Inc.'s coupon-bearing notes due December 2014 linked to the stock of Ford Motor Co. are designed for investors seeking above-market yields who do not expect to earn anything above the coupon, said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

"What makes the offering interesting is that a lot of investors are looking for yield," he said.

"Now obviously, you're not going to participate in the price increase of the stock."

Interest is payable quarterly at a rate of 6% to 7% per year. The exact rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the final price of Ford stock is greater than or equal to 95% of the initial price, the payout at maturity will be par of $10.

Investors will share in losses beyond the 95% threshold value.

The structure is that of a reverse convertible, said Medeiros, with a few non-typical terms. One is the existence of a buffer in place of the typical barrier. The other is the final observation date rather than a daily observation. Finally, investors are not "put" the stock at maturity if the share price declines below the 5% buffer.

"Obviously, with the 30-year Treasury at 3.8%, this particular coupon of 6% to 7% is pretty attractive," he said.

But the notes offer another benefit to investors as a fixed-income alternative, he said.

Bond alternative

"It also makes sense to pursue a yield alternative based on equity instead of buying a traditional debt instrument when you consider the context of future interest rates rising. And right now rates are rising," he said.

He pointed to the 30-year Treasury rate at 3.8% Thursday, which is 80 basis points higher than six months ago and more than 100 bps higher than a year ago.

"Even if rates are still historically low, over the last year or so, they started to spike," he said.

"For any bond investor, as interest rates rise, principal goes down.

"In this case you have a coupon that's much higher than the risk-free rate, and the upside is tied to equity. If the stock performs well, if the price of Ford doesn't change, it won't affect the coupon. That's a plus compared to a straight debt instrument.

"In comparison, if you invest in the 30-year government bond at 3.8% and rates move to 3.9%, the price is dropping.

"Assuming that the stock stays stable, this structure gives you a hedge against interest rate risk."

Not for bulls

Investors, however, will not participate in any increase in the price of the stock, the prospectus warned in the risk section.

As a result, the notes are not an "appropriate" investment for those who expect the share price to "increase substantially," according to the prospectus. The noteholders could end up earning less than the stock investors.

"The downside is that if Ford performs well, you surrender your appreciation for a coupon. It's attractive only for the income investor, not for the bull who should expect the stock to rise further," he said.

Asked whether he was bullish on the stock, Medeiros said, "Automakers over the next year should fare well.

"Certainly Ford has done very well. Does it mean the stock has reached its top? I don't think so. Even [though] the stock has appreciated over 30% year to date, it's still trading at a PE of 12."

Ford's share price is up 32% so far this year.

"If you're looking for yield and a fixed-income alternative in your portfolio, it makes a lot of sense," he said.

"But don't do it if you're bullish on the stock. This is an income play, not a growth play."

Huge gap

Steve Doucette, financial adviser at Proctor Financial, considered the risk reward profile of the product and was not "impressed" by the buffer and the coupon.

"I'm not going to like it. You're capped at 6% to 7% with pretty much all the downside risk. There is a buffer, but 5% is almost nothing, especially for a stock," he said.

"We wouldn't even look at it.

"First of all, we're not stock pickers. We are asset allocators. We don't make bets on single stocks, single commodities or specific countries."

Doucette, who buys his structured notes through a dialogue with issuers and not from the registered "shelf," said that he sees a "huge gap" in pricing between one-off products and the off-the-shelf products.

"If you look at what's there off the shelf, there isn't much of anything. We rarely pay attention to these notes," he said.

"Instead, we have brokers who come up with their own sheets, comparing prices from different issuers. I just received one on three-year buffered notes. We use that to price our own deals, have the issuer customize the best terms for us after soliciting their best offer through a competitive process.

"You have no idea of the huge gap between this and the calendar. Calendar offerings are stuff that the brokers are pulling out, pushing off.

"When you know what you want and how to get it, you get much better terms and very different deals."

The notes are expected to price in November and settle in December.

BofA Merrill Lynch is the underwriter.

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