HSBC's four-year notes with 70% trigger tied to S&P 500 suggest investors prioritize buffers

By Emma Trincal

New York, Oct. 16 - When pricing conditions leave issuers with little room to price defensive structures, advisers said they often agree to extend duration if it improves significantly the terms, in particular if the reward in the tradeoff is to obtain an attractive buffer.

A case in point is HSBC USA Inc.'s 0% buffered notes due Nov. 7, 2016 linked to the S&P 500 index.

The product has a four-year tenor; but, it protects investors from the first 30% losses, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus any index gain. There is no cap.

Investors will receive par if the index falls by up to 30% and will lose 1.428571% for every 1% decline beyond 30%.

Still a buffer

"The biggest negative is the four-year term, of course," said a financial adviser. "But I like the fact that you don't care about what's happening between day one and maturity. It's a point-to-point payout. I also like the fact that you have a buffer, not a barrier. You don't suffer the first 30% losses," he said.

He agreed that the downside leverage factor of 1.428571 made the type of buffer used in this particular structure less attractive than a regular buffer, which would have simply featured a one-for-one downside beyond the buffer without magnifying the losses.

A 40% index decline for instance would cause investors in the notes to lose 14.28% versus 10% if the buffer had not been leveraged, he noted. But at the same time, a 70% barrier - or the equivalent of a 30% soft protection - would have translated into a loss of 40%, or the equivalent amount of the index decline.

"It has negative leverage but you lose 14%, not 40%. It's still a buffer," he said.

"I really like having a big buffer even if you have to worry about accelerated losses. I've seen leverage kicking in after much smaller ones, like 10%. This is 30%. The accelerated loss starts only after you hit a pretty large, substantial buffer. And it's hard to imagine the S&P going down 30%," he added.

This adviser compared the structure with a recent deal sold by JPMorgan on the behalf of the same issuer.

The structure also featured a 30% downside protection in the form of a knock-out observable any day. If a knock-out never occurred, investors were to receive the index return subject to a 7.3% contingent minimum. But if the knock-out did occur, they would lose both the protection and the contingent minimum return.

The notes, due April 16, 2014 were tied to the Euro Stoxx 50 index.

Trade off

"The Euro Stoxx is more volatile than the S&P. It's shorter but there's more risk," he said.

"I like the four-year better. It' a little bit too long. I'd rather see three-year or three-and-a-half year with less generous terms.

"But the idea of getting much better terms by extending the duration makes sense to me. There are limits however and those limits vary from adviser to adviser. For me, three-year is a good limit," he said.

Dean Zayed, chief executive officer at Brookstone Capital Management , said that he felt comfortable with the four-year notes tied to the S&P 500 due to the 30% buffer.

"Normally we prefer short-term maturities, but four-year is not too long and the 30% [buffer] is attractive," he said.

"There is a bit of luck involved since the market could always tank. But over most four-year rolling periods, you're not going to see too many when the market is down 30%. In this particular period though, you could have that. Even though it has only happened in very few cases, the next four-year period could be the one when it's down 30%. However, I still think the stats are on your side and that it's unlikely."

Zayed added that he liked the way the product was designed.

"I like the simplicity of the structure. Most of my clients would understand it," he said.

When he compared the notes with the shorter-dated HSBC product tied to the Euro Stoxx index with a 70% barrier, he said that: "I think I'm more comfortable with the four-year. The other one is more of a tactical play in the crucial upcoming 18-months.

"During that timeframe, I could envision a 30% correction. It's a bit of a risky play if you lose that protection. It could really be a real loser," he said.

HSBC Securities (USA) Inc. is the underwriter.

The notes will price on Nov. 2 and settle on Nov. 7.

The Cusip number is 4042K17C1.

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