HSBC's 8%-10% one-year autocallable notes linked to S&P, Russell feature singular payoff

By Emma Trincal

New York, Feb. 3 - HSBC USA Inc.'s 8% to 10% autocallable yield notes due March 1, 2013 linked to the S&P 500 index and the Russell 2000 index present a mixed risk picture and an usual payout that combines elements of reverse convertibles and autocallables, said Suzi Hampson, structured products analyst at Future Value Consultants.

The return is based on the worst-performing of two indexes, making the notes more risky than traditional reverse convertibles and autocallables alike, she said. But their autocallable feature makes them less risky than reverse convertibles.

Interest is payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par if each index closes at or above its initial level on any of four quarterly observation dates.

The payout at maturity will be par unless either index dips below the 75% trigger level during the life of the notes and either index finishes below its initial level, in which case investors will receive par plus the return of the worst-performing index.

"This is for an investor who accepts the idea of an early exit and whose market view is relatively flat. He's not worried about any of the two indexes falling as long as they don't drop by more than 25%. All you need is for the indexes to pretty much stay at the same level and you get a decent return," she said.

Hybrid

The fixed coupon distinguishes the notes from an autocallable, she said.

"With an autocall, your return depends on the performance of the underlying. Typically you need the underlying to grow in order to get called. That's what triggers the payment of the call premium. Here, you get your coupon no matter what, just like with a regular reverse convertible," she said.

However, not all reverse convertibles are callable; in fact, most are not, she noted.

"It's really a callable reverse convertible. It's not the most common type of reverse convertible. It has some features of an autocallable and some features of a reverse convertible. It's a hybrid. Because it's callable, the product is less risky than a traditional reverse convertible, she said.

Hampson noted the disparity between what triggers a call and what triggers the breach of the barrier.

For the call to occur, both underlying indexes have to close at or above their initial levels, and the observation period is only quarterly. On the other hand, it only takes one index to breach the downside barrier and it can happen any day, according to the prospectus.

"If two indexes can hit the trigger anytime, it adds a lot of risk. It's very different than having a basket with the two indexes," said Hampson.

"But the benefit of the worst-of is that it's supposed to give you a much better return than if you were only tied to just one underlying asset," she said.

For the rating of this product, Future Value Consultants looked at a group of other callable reverse convertibles of various maturities, underlyings and barrier levels.

Mixed risk picture

The riskmap, a Future Value Consultants score, reflects the risk associated with a product. The higher the riskmap is on a scale of zero to 10, the higher the risk is.

The product received a 4.51 riskmap, which is slightly more than the average 4.19 riskmap for its peers.

"It's a combination of things," said Hampson.

"Your 75% barrier is quite normal. You get 80% on a three-month reverse convertible, so for a one-year [note], 75% is standard," she said.

"The worst-of feature adds to the risk, obviously, because you're really tied to the worst of the two indexes. But another factor offsets the risk a little: the call feature.

"If you get kicked out, the product terminates and you get your principal back. You're no longer at risk. That's what makes this note a little less risky than most reverse convertibles," she said.

When compared to other notes, in particular autocallables, this product offered an additional cushion of safety, she said.

"There is a little bit of loss you can absorb without losing your principal. Say you finish down 90%. You get a 10% coupon. You're even. This gives you a little bit of leeway," she said.

The riskmap is the sum of two risk components: market risk and credit risk. The bulk of the risk with this product comes from the market risk rather than credit risk, she said.

At 4.01, the market riskmap is higher than 3.76, the average score for other similar products.

"Again, this is due to the worst-of feature and the correlation risk," she said.

Low return score

Future Value publishes a return score, which measures the risk-adjusted return of a product on a scale of zero to 10. It is calculated under reasonable and consistent forward-looking assumptions.

"This product doesn't have a high return score," said Hampson.

At 5.73, the score is less than the average return score of similar products, 6.14.

"The worst-of feature should in theory give you a better return than what you'd get with a reverse convertible. But I guess it depends on the underlying stock you're comparing it with," she said.

"You have a high probability of big capital losses due to the worst of. In addition to that, your upside is capped. This somewhat lower return score means that you probably have products out there that offer a higher potential return for the same amount of risk."

The return score derives from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

While the probability of making between 5% and 10% is 76.6%, investors can also lose a large amount of capital as evidenced by a 16.2% probability of losing more than 15% of principal.

Exotic options

With its price score, Future Value estimates the real value of a product to the investor after deducting on an annual basis the costs the issuer charges in fees and commissions. The score, calculated on a scale of zero to 10, is 5.08 for these notes versus 6.65 for comparable products.

"It's quite lower, and it could be because the options used here are more complicated than plain vanilla options, so it would cost the issuer more. In addition to that, the correlation between the two indexes may make the options more costly for the bank to hedge. That may be built into the cost," she said.

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.

This product scored 5.40 on the overall versus an average of 6.39 for the same product type.

"We're losing one an a half point on the price score and half a point on the return score, so you get that lower overall score. It's definitely below average, and the price score here has the biggest impact," she said.

HSBC Securities (USA) Inc. is the underwriter.

The notes will price on Feb. 24 and settle on Feb. 29.

The Cusip number is 4042K1WV1.

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