HSBC's auto cap annual income notes on 12 stocks offer principal protection, capped coupon

By Emma Trincal

New York, June 21 - HSBC USA Inc.'s upcoming annual income opportunity securities with auto cap due July 30, 2015 linked to 12 common stocks offer principal protection and an attractive income opportunity, but some sources said that the fluctuating coupon and auto cap rate may be a drawback for some investors.

The basket includes Amazon.com, Inc., Applied Materials, Inc., Archer-Daniels-Midland Co., Bank of America Corp., Berkshire Hathaway Inc., Exelon Corp., First Solar, Inc., Gilead Sciences Inc., Newmont Mining Corp., Pfizer Inc., Verizon Communications Inc. and Waste Management, Inc., according to an FWP filing with the Securities and Exchange Commission.

Interest will be payable in June or July of each year and will equal the average of the returns on the basket stocks, subject to a floor of 1% and a cap of 6.5%. Each stock will have an auto cap rate of 6.5% and a floor of negative 20%.

The payout at maturity will be par.

Capped, no participation

The prospectus stated that the notes are suitable for investors who seek 100% principal protection with an annual coupon fluctuating between 1% and 6.5% based on the average performance of the stocks composing the basket.

The risk for investors is to receive only the minimum coupon of 1%, according to the FWP filing.

Another risk factor is that investors "will not directly participate in any appreciation in the value of reference stocks" and that their "coupon is capped."

The structure is aimed at income investors who hope that the basket performance will be sufficient to provide "a satisfactory return on [the] investment," according to the prospectus.

Coupon at risk

But some sources said that fixed-income investors may be reluctant to invest in an instrument that pays an uncertain stream of income.

Adrian Neave, a U.K.-based distributor with Gilliat Financial Solutions, compared these notes with a reverse convertible structure, emphasizing the difference.

"We've seen income products, but they're usually reverse convertibles, which is very different. In a reverse convertible, you have the certainty of income, which you don't have here. I would be surprised if there was a great interest in this product. People are more prepared to put capital at risk than coupon at risk," Neave said.

Norman Papoose, president of Evaluate My Advisor, agreed.

"With those notes, you have a fluctuating coupon and no chance for capital appreciation," he said.

"The point of fixed-income securities is to know what your income stream is going to be," he added.

Looking at the five-year Treasury rate of approximately 2.12%, Papoose said, "The inflation risk is pretty high here with the uncertain coupon. You could earn only 1%, much less than Treasuries. And you're still subject to the issuer's credit risk. If I had to take HSBC's credit risk for [a] five-year [bond], I would be much more inclined to invest directly in their corporate bonds," he said.

Auto cap and floor

Another drawback for some market participants is the method used to calculate the basket performance.

Each year, the performance of the underlying basket is determined based on the average performance of each individual stock. But each stock is subject to a return floor limiting the negative performance to 20% while the auto cap limiting the gains for each stock is only 6.5%.

Such a discrepancy between a cap lower in absolute terms than the floor adds some risk, Papoose said.

As stated in the prospectus: "Extreme increases in the prices of one or more reference stocks will not fully offset equally extreme declines in the prices of one or more reference stocks."

"One loser could have a strong negative impact," Papoose said. "There's three times as much room beneath you as there is above. You can fall 20 floors but you can only go up six floors. The downside risk is inequitable."

The securities will price on Friday and settle on June 30.

HSBC Securities (USA) Inc. is the agent.

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