HSBC's 18-month twin participation notes tied to S&P 500 aimed at cautious, agnostic investors

By Emma Trincal

New York, Jan. 13 - HSBC USA Inc.'s 0% twin participation notes due July 25, 2013 linked to the S&P 500 index are for cautious investors who do not have a view on the direction of the underlying index but who expect the moves to be limited, said structured products analyst Suzi Hampson at Future Value Consultants.

The structure falls into the definition of a "straddle." It offers positive returns even if the S&P 500 declines as long as the decline is above a specified trigger level.

With this note, a trigger event occurs if the index closes below 70% of the initial level on any day during the life of the notes, according to an FWP filing with the Securities and Exchange Commission.

If a trigger event has not occurred and the index finishes above the initial level, the payout at maturity will be par plus the index return, up to a maximum return of 18% to 23%. The exact cap will be set at pricing.

If a trigger event has not occurred and the index finishes at or below the initial level, the payout at maturity will be par plus the absolute value of the index return.

If a trigger event has occurred, investors will receive par plus the index return, up to the 18% to 23% cap and with exposure to any losses.

Uncapped downside

"This is not for the very bullish investor because your upside is capped at 18% to 23%. If you're a real bull, you would want a higher cap or no cap," said Hampson.

She noted that investors could in theory make more on the downside than on the upside. The 70% trigger level permits a gain just below 30% while returns obtained from index appreciation will not exceed the maximum 23% cap.

"You make the most money when the price falls a lot but at your own risk," she said.

"If it finishes down at 28% or 29%, you receive a positive return for the same amount. But if it finishes at 30%, you breach the barrier.

"As the index declines and gets closer to the 30% threshold, the product will be very sensitive to any movement of the underlying. A 1% move could be the difference between a 29% gain and a 30% loss. So this is definitely not a bearish note.

"There are so many other products out there that cap the downside, while this one doesn't. If you're really bearish, why would you do that?"

Straddles, which allow investors to make money regardless of the direction of the underlying but within a range, are not a very common type of structured product, said Hampson. One way to evaluate the product is to compare it with another note that offers a 100% upside participation, she said.

"Other one-for-one upside products do not have the potential to earn on the downside like this one. But on the other hand, they have a higher cap or even no cap at all," she said.

She gave the example of Credit Suisse AG, Nassau Branch's $6.41 million of 0% index knock-out notes due June 26, 2013 linked to the S&P 500, which priced in December.

"You had a 73% barrier, the same maturity and the same underlying. But it gave you 100% participation with no cap, so your potential upside was unlimited," she said.

"It's really up to the investor to decide what's best. He has to weigh in which features he prefers. Does he want the unlimited upside or the possibility to generate a gain from a declining index?

"If you're cautious, getting a return from the downside can be attractive. It gives you a payoff that most products don't have. It definitely has an appeal."

Can't have it both ways

However, Hampson pointed to some of the shortcomings of the structure.

"Those straddle type of products tend not to score very well. It has to do with volatility," she said.

"On the one hand, you don't want to lose capital. If the index is very volatile, you can easily breach the barrier, and you don't want that. That's how you lose money. So you're short volatility.

"On the other hand, nothing in this product is there to boost your upside potential. You don't have any gearing. You're not getting a digital return. And you have a cap.

"So in a way, you need the underlying to be volatile to yield some return, but you don't want it to be too volatile. Too much volatility makes you lose capital, but too little doesn't give you any positive return.

"It's very different from a digital or a reverse convertible, for instance, where you don't need the volatility. With those products, you go short volatility and it works to your advantage. Here, you're going short volatility but you need the volatility to generate a positive return. It sort of contradicts itself."

Return score

This limitation is reflected in the product's return score, which at 6.13 is lower than the average of all products of 6.38.

The return score is Future Value Consultants' opinion of the risk-adjusted return under reasonable and consistent forward-looking assumptions for underlying asset evolution on a scale of zero to 10.

"The absolute value return is an attractive feature, but it has a cost - the cap. That's one of the reasons the return score is not that high," she said.

Future Value Consultants evaluates with its riskmap the risk associated with a product on a scale from zero to 10.

The 4.81 riskmap for the notes is below 4.92, the average of all products.

The fact that investors can earn a positive return even if the index finishes down by 30% does not limit the risk, she said. What matters is also the amount of capital that can be lost. In this case, investors can lose up to 100%, she said.

Price, overall

Future Value Consultants uses its price score to measure on a scale of zero to 10 the real value to the investor after deducting on an annual basis the costs the issuer charges in fees and commissions.

The notes received a 5.34 price score, compared with 6.75 for all other products.

"This price score is quite below average. That could be because you have more options involved. It's also because there are very few products of this kind. So maybe pricing is not as competitive as it is with a growth product or a reverse convertible," said Hampson.

Future Value Consultants offers its opinion on the quality of a deal with its overall score, the average of the price score and the return score.

The overall score of the product, 5.73, is also below the average of 6.67.

"This product doesn't reflect any particular market view," she said.

"The main thing is for the index not to drop by more than 30%. As long as it stays above 70%, you don't really care.

"But there are so many products where you get a fixed return and you just want the index to stay flat.

"It's a strategy that offers the best return in a neutral or low volatile market. Although the earnings on the downside can boost your return, the cap on the upside limits your potential gain quite a bit. One sort of offsets the other," she said.

HSBC Securities (USA) Inc. is the agent. The notes will price on Jan. 20 and settle on Jan. 25. The Cusip number is 4042K1VL4.

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