HSBC's $107.47 million 7% STEP Income notes linked to Ford seen as reverse convertible-like

By Emma Trincal

New York, June 4 - HSBC USA Inc.'s $107.47 million of 7% STEP Income Securities due June 12, 2015 linked to the common stock of Ford Motor Co. were designed for investors seeking higher yield. A sellsider described the structure as a variation of a reverse convertible with some "tweaks."

The offering was the largest one to price last week, according to data compiled by Prospect News.

BofA Merrill Lynch was the agent.

If the final price of Ford stock is greater than or equal to the step level, 107% of the initial share price, the payout at maturity will be par plus 1.51%.

If the final share price is greater than or equal to the initial share price but less than the step level, investors will receive par.

Investors are fully exposed to any decline in the share price.

Interest is payable quarterly.

Income play

"It's an income-driven trade. Seven percent for a one year is an attractive rate of return, especially when you look at the low volatility in the market," a market participant said.

Investors agreed to see their return limited to 7% plus the potential 1.51% step payment, according to the prospectus. In exchange, they had to accept the one-to-one downside exposure and the non-payment of dividends.

The share price of Ford has gained nearly 9% this year. The stock has a dividend yield of 3%. Its implied volatility is about 16% versus 10% for the S&P 500 index.

So many steps

The STEP Income Securities sold last week were one of the many forms of step-up notes, a sellsider said.

"You have the autocallable step-ups where you get a premium if you get called. At maturity, if you haven't been called, you get either the step, like a digital payout, or the index return if you finish higher than the step," he said.

"This note is different from those market-linked versions. It's a step-up too, but it's not giving you any participation. This is more of an income product.

"They pay you a 7% fixed coupon no matter what. Then if you hit 107% at maturity, they give you an extra coupon of 1.51% ... some sort of a bonus.

"What you have here is a reverse convertible since you have the coupon and not the upside.

"Call it a reverse convertible with a digital option. The additional 1.51% coupon is a very small thing. But each time you get one new thing, you have to give up something else."

Investors in the notes would give up the upside compared to those buying step-up market-linked notes, he noted.

"One gives you a fixed coupon but no upside. The other, if the index is above the step level, gives you participation but no coupon.

"This one gives has a fixed return of 7% and perhaps 1.51% on top of that, but it's not a guarantee."

Reverse convertible equivalent

The sellsider compared the STEP Income Securities with a straight reverse convertible.

"You could imagine an alternative to this note in a typical reverse convertible. They would pay you a higher fixed interest of 7.75% for instance instead of 7%, but they would eliminate the rest of the structure: no contingency with a 1.51% bonus coupon, no 107% knock-in. So you would get only half of the contingent coupon, but it would be a sure thing. No need to hit the 107% level anymore," he said.

The choice between the hypothetical reverse convertible described in his example and the Ford-linked notes depends on the investor's mindset, according to this sellsider.

"Should I go for the extra 75 basis points and eliminate the contingency? Or should I take the chance of getting only 7% in order to get an extra 75 basis points, in which case I have to hit the 107% level? These are the questions an investor needs to answer for himself," he said.

The example illustrated that the deal is "very similar" to a reverse convertible only with a different "thought process," he said.

"You want more yield, and you are willing to introduce an element of uncertainty to get it as a bonus. But it's not guaranteed," he added.

Tweaking

While the HSBC notes are in nature reverse convertibles, the formula used by the agent is different.

"This is an example of Bank of America taking a classic structure, a reverse convertible, and tweaking it a little bit. Is it very new, very earth-shattering? No. But it gives investors more options to play around the same theme," he said.

Step-up notes offer a broad range of variations, he said.

"This one is a play around the reverse convertible theme. Others are autocallables with a digital payout for any gains below the step level and uncapped participation when you hit that level. Some give you the same thing without the autocall feature," he said.

"When a market-linked step-up offers unlimited upside, you're talking about a different kind of investor. It is obviously more of a bullish play. To get that, especially without the cap, you probably need a longer term. You can't have it both ways."

The right view

Noting that the notes offer no downside protection while some step-ups do have small buffers, he said that comparing structures is very challenging because not all terms are ever the same.

"This one may not have a 5% buffer, but you do get a 7% coupon. It's a 7% cushion. You can't really say it has nothing to protect you against losses," he said.

Ultimately, investors have to decide what type of structure is best for them.

"There are many ways to use the same type of structure to fit the needs of different kinds of investors with different views," he said.

"A structure is a good one to the extent that it allows you to express your own view."

The notes (Cusip: 40434C543) priced May 29.

The fee was 1.75%.

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