HSBC offers reverse notes linked to worst Dog of Dow; product could be binary play, adviser says

By Kenneth Lim

Boston, April 8 - HSBC USA Inc.'s planned reverse convertibles linked to the worst performer of the Dogs of the Dow looks to be a binary play, an investment adviser said.

HSBC launched the 25% reverse convertibles due Oct. 30, 2008 linked to the worst performer of the March 2008 Dogs of the Dow stocks.

The stocks underlying the HSBC notes are Bank of America Corp., Citigroup Inc., AT&T Inc., Pfizer Inc., JPMorgan Chase & Co., Merck & Co. Inc., General Electric Co., Verizon Communications Inc., General Motors Corp. and E. I. Du Pont De Nemours & Co.

Investors will receive par at maturity unless any of the underlying stocks trades below 50% of its initial value and any of the underlying stocks finishes below its initial value. If those two conditions are met, the payout at maturity will be the number of shares of the worst performing stock equal to par of $1,000 divided by its initial price.

The Dogs of the Dow is an investment strategy that identifies the 10 stocks on the Dow Jones Industrial Average with the highest dividend yield, based on the idea that not only do those blue chip stocks offer the best yield but that they are also poised for a rebound.

"The idea is the Dow Jones Industrial Average usually consists of high enough quality stocks that the ones that are beaten up...will tend to come back relative to the others, but I don't have any color on how successful it has been," Tiemann Investment Advisors president Jonathan Tiemann said.

At first glance, the HSBC product looks complex, Tiemann said.

"It sounds like you are in effect, as an investor, you're giving HSBC a sort of very complex compound put option on this," he said. "That's actually quite a bet."

He noted that with the 25% annualized coupon and the 50% barrier, the notes will probably do either very well or very poorly.

"It's a risky bet in the sense that it's got a high variance outcome," he said. "You could do real well, you could earn 13% to 14% in just over six months or you could be pretty well hosed, and you could easily lose half your money or more."

An outcome near the middle is unlikely, he added.

"What's interesting is that it's unlikely you'll gain or lose a little if you really think it through," Tiemann said. "Yeah, there's a pretty good chance you'll get that 25% annualized, but there's also a reasonable chance you're going to lose a lot of money."

"What's happening of course is the investor is writing to HSBC a complex put option on this collection of securities," he added. "It's not exactly an option on a portfolio...but in fact the outcomes for the investor are pretty much a binary play. The likely outcomes are either real good or real bad and the middle outcomes are rather unlikely."

HSBC is probably not as concerned about the outcome, Tiemann said.

"This one is complex enough that it would be hard to work out what the pricing is," he said. "Structured products have this feature where it usually looks like you're betting against the issuer, but actually the issuer usually has their exposure hedged somehow, so in reality the issuer doesn't really care how it comes out. However it comes out, the structured products game is to earn money. They will have to commit some firm capital for the hedge position...What they could be doing in one way or other is sell put options on the other side. They are in essence covered, but if everything stays where it is, then what they collect on the put options probably support that premium interest rate."

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