HSBC absolute return CDs on S&P offer cash alternative, equity returns in up and down markets

By Emma Trincal

New York, Dec. 8 - Prudent investors looking for cash alternatives with a potential equity-linked return may be interested in absolute return certificates of deposits, which give them the absolute point to point return of an underlying index regardless of its direction as long as the index moves up and down within a certain bound.

In a current example of the structure, HSBC Bank USA, NA plans to price 0% absolute return certificates of deposit due April 26, 2012 based on the S&P 500 index, according to a term sheet.

If the index never closes above the upper barrier or below the lower barrier, the payout at maturity will be par plus the absolute value of the index return.

The upper barrier will be 122% to 127% of the initial index level, and the lower barrier will be 85% of the initial level. The exact upper barrier will be set at pricing.

Otherwise, the payout will be par.

A repeat deal

HSBC has been offering this product, under various maturities and barrier levels - for the most part 22-month, 24-month and 28-months, usually once a month for many months, a sign that investors are still showing appetite for principal-protected structures with potentially higher rates of return than money market funds or regular CDs. The barriers for those deals have usually been in the 22% to 32% range, depending on the maturity.

Absolute return

Another attractive feature in this product is its absolute return quality, something that investors appreciate at a time when the market may have reached a turning point, with many predicting that the U.S. equity rally that began in March is now on its last legs.

"The pricing certainly indicates that the expectation of the investor is a range-bound market," said Steve Braverman, president of Harris myCFO in Fort Lee, N.J.

Looking at the upper barrier, which could be as high as 27% and comparing it to the 15% lower barrier, he said that, "It's appropriate that you would have more upside because 28 months is a long time. And it still gives you some level of protection. The slightly bullish bias is helpful."

The deal is designed for conservative investors, according to Braverman. "To me this investment is more about not losing than making money."

Duration, duration

While the principal is guaranteed by the Federal Deposit Insurance Corp., Braverman underlined the risk for investors of "earning nothing" at maturity since "it only takes one time" for the upper barrier or lower barrier to be breached any time during the term of the CD.

"For this type of longer duration, I might prefer a product that has some leverage and is capped," he said.

"With a long duration, it's hard to expect that over two years the market is going to stay range bound and that no barrier is going to be breached on a single close. It's not a point-to-point product and as a result, at any point, you can be stopped out of the market," he added.

Exit strategies

Braverman said that he likes absolute return products but that he uses those investments for a specific type of situation, in which case he would opt for a shorter duration.

"We've done absolute return products but usually I give it to people who are thinking of getting out of the market," he said. "Instead of just leaving, the idea is to allocate to an absolute return product as a way to give them an opportunity to make money before leaving. If the market is down, they might make some money and they won't lose. If the market is up, they might make money too."

Braverman said that he would typically apply that exit strategy with shorter-dated absolute return products, usually with a maturity of 15 months.

Balancing act

Investors in the CDs are only moderately bullish or bearish and they need to believe that the volatility of the S&P 500 is not going to increase over the 28-month period, said structured products analyst Suzi Hampson at Future Value Consultants.

"You want the volatility of the underlying to be pretty steady. You don't want the index to move too much.

"If you think of it logically you need the index to be far away to get a return, but if it moves too much you increase the likelihood of breaching the barrier and you get nothing," said Hampson.

"In a little bit more than two years, expecting the S&P not to fall by more than 15 days - and anticipating that it won't happen on any given day - is quite optimistic," she said.

A cash alternative

With rates so low, people are looking for cash alternatives with principal protection, said Hampson, which explains investors' interest for those products.

"With a CD, the protection is an incentive for the investor. If you sacrifice the potential to get a two-year regular CD return you may eventually get more; while when you're in cash, you're done, there is no return. Compared to cash it could make sense," said Hampson.

Tony Proctor, president of Proctor Financial, a wealth management firm in Wellesley, Mass., said that absolute return CDs may be used as cash alternatives but that structure and terms do matter. Looking at this specific CD, he said that he would consider it, providing there were one or several structural changes.

Rebate please

"I would look at it favorably as an alternative to cash, but I think it could be more creative by having a rebate built into it if a barrier is broken," Proctor said. "For instance, if the barrier is broken on the upside, the client receives a rebate of 4%, some sort of contingent minimum rate if you will."

He said that the HSBC 28-month CD may be more difficult to "position as a cash alternative" knowing that "the least return you can get is zero."

He compared a potential zero interest that may be the result of an investment in the HSBC absolute return CD with the 1% annualized return investors may expect to earn with a regular CD, saying that "At least, the issuer should be competitive with a cash return under every circumstances."

"I've seen other structures with rebates, but there were notes, not CDs. It can be done though. It's just a matter of how you price it," Proctor said.

Other tweaks

Proctor offered other suggestions to make the CD terms more attractive to investors.

"If it was calculated point to point, I would recommend it. But I don't think the economics support this option. I don't think it's feasible," he said.

A shorter maturity would also be "helpful," he said, as it would reduce the probability of breaching the barriers either on the upside or downside.

The barrier range could also be less narrow, he suggested.

"It would concern me a lot that I have to stay within the range during that period of time. I don't think it's realistic when you know that the market has been up almost 60% since March. It's more the downside that concerns me," he said. "If the range was bigger on the lower barrier, it would make me feel better."

Overall, Proctor said that absolute return CDs serve a purpose but that the timing for these types of investments may not be optimal.

"Absolute return CDs are a difficult sale in this environment because volatility is so low, it makes it difficult for issuers to offer great terms," he said.

"The only way to position it would be as a cash alternative and [the issuers] would have to figure out a way to be competitive in the cash arena with a rebate rather than to push it as something trying to give a good equity-like return," he concluded.

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