Leveraged short notes tied to S&P 500 lose too much liquidity to warrant risk, advisers say

By Emma Trincal

New York, Oct. 19 - New offerings of leveraged bearish notes tied to the inverse of the S&P 500's performance are well timed for investors who believe recent bullish momentum may have reached a turning point - but financial advisers warn that the instruments may be too illiquid and lacking in downside protection to warrant the risk of leveraged losses.

UBS AG for instance plans to price one-year 0% double short leverage securities linked inversely to the performance of the S&P 500 Total Return index, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus double the absolute value of any losses plus the interest amount minus the accrued borrow cost. But if the index gains, investors will receive par minus 2% for each 1% gain plus the interest amount minus the accrued borrow cost, according to the filing.

Bears' come-back

"It's interesting that we think the market has gotten ahead of itself and that we're going to see some correction. But year out, it's a different story," said Steve Doucette, financial adviser with Proctor Financial in Wellesley, Mass., who added: "If anything, I think the market may be up a year from now."

The notes will be called if the index rises above 135% of the initial index level. "I guess it's a 35% negative cap, but still we wouldn't be interested," said Doucette.

"It's nice if the issuer can give you some secondary liquidity because if things get really ugly, you can clear out. And in some cases we've had some luck being able to move out of a structure into another. But it doesn't say anywhere that it's the case here."

"It may be useful as a hedge for a portfolio, but it's not worth the risk given the lack of downside protection," said Doucette. "So I don't think we would be interested in that type of structure."

Other terms of the notes include that they will price at 102.3.

The interest amount will equal the interest accrued on three times the principal amount of the notes at a rate per year equal to overnight Libor, and the borrow cost will be overnight Libor minus the Fed Funds Open Rate plus 15 basis points.

Limited secondary market

Bret Rosenthal, a hedge fund manager at Rosenthal Capital in Jupiter, Fla., also criticized the notes' lack of liquidity, saying that they track the reverse performance of the S&P on a leveraged basis without taking into consideration what happens any time during the one-year term.

"It's not worth the risk because a security like that should be very liquid, but instead it's going to trade at a discount off S&P," he said.

"You're invested in these notes for one year. Now imagine that after three months, the S&P 500 falls by 10%. Your notes should be up 20% but they won't because you won't find a liquid market for it. At the end of the term, you'll lose some of your principal if the index is up. And you'll never get the full benefit of any decline of the index that occurs anytime during the term," said Rosenthal.

On that point, the product supplement filed with the SEC says in the risk section that "there may not be an active trading market in the securities" and that "sales in the secondary market may result in significant losses."

Unpaid liquidity premium

Rosenthal said that bearish investors who want to bet against the S&P 500 are much better off buying exchange-traded funds that inversely reference the S&P index, such as the ProShares Short S&P 500, because unlike the short leveraged structured notes, they offer a liquidity advantage.

"ProShares at least trades presumably closer to the inverse index. Since there is strong liquidity, you can capitalize on your gains when the index falls and sell your investment at any time with a profit," he said.

"My problem with these notes is that it's a yes or no bet over the next 12 months. If the market drops at any time, you want to be able to sell and recognize that gain. But here you can't. It's not liquid enough for you to get paid. I don't think it's worth the risk."

An issue of notes due Nov. 11, 2010 will price Nov. 5 and settle Nov. 10.

Other similar issues will price Nov. 19, Dec. 9 and Dec 17.

UBS Investment Bank and UBS Financial Services Inc. are the underwriters.

Shorter version

In addition to the one-year notes, UBS AG also announced plans to sell three-month 0% double short leveraged securities linked inversely to the performance of the S&P 500 Total Return index, according to a 424B2 filing with the SEC. The notes will price at 101.3.The notes will be called if the index rises above 135% of the initial index level.

If the notes are not called, the payout at maturity will be par of $10 plus double the absolute value of any losses plus the interest amount minus the accrued borrow cost. If the index gains, investors will receive par minus 2% for each 1% gain plus the interest amount minus the accrued borrow cost.

The interest amount will equal the interest accrued on three times the principal amount of the notes at a rate per year equal to overnight Libor, and the borrow cost will be overnight Libor minus the Fed Funds Open Rate plus 15 basis points.

Several issuances for this deal are coming up with pricing dates on Nov. 5, Nov. 19, Dec. 3 and Dec. 17

UBS Investment Bank and UBS Financial Services Inc. are also the underwriters.

Four times leverage

Separately, HSBC USA Inc. priced on Oct. 7 an offering of $5 million of 0% bearish return enhanced notes due Nov. 2, 2011 linked to the S&P 500 index, according to a 424B2 filing with the SEC.

The payout at maturity will be par plus quadruple the absolute value of any decline in the index, up to a maximum return of 97.4%. Investors will lose 4% for each 1% gain in the index.

J.P. Morgan Securities Inc. is the agent.

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