HSBC's14-month leveraged capped notes tied to Nikkei target moderate bulls with specific view

By Emma Trincal

New York, Feb. 19 - HSBC USA Inc.'s 0% Accelerated Return Notes due April 2014 linked to the Nikkei Stock Average index are designed for investors who want to jump on to the Japanese rally bandwagon without expecting too much upside, sources said.

The payout at maturity will be par of $10 plus triple any gain in the index, up to a maximum return of 12% to 16%. The exact cap will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will be exposed to any losses.

BofA Merrill Lynch is the agent.

Dean Zayed, chief executive officer at Brookstone Capital Management, observed that investors in the notes have a mixed bullish outlook.

"They have enough confidence to be comfortable without any downside protection, but at the same time, their growth expectations are somewhat limited," he said.

Investors hit the cap if the index gains 4% to 4.67% over the period, which is the equivalent of 3.43% to 4% per annum, when taking into account the three-times leverage factor.

Modest gains

"We've certainly seen a recent rally in the Nikkei," Zayed said.

The Japanese stock index is up nearly 10% this year. In the past 12 months, it has gained 20%.

Japan's Prime Minister Shinzo Abe, elected in December, has spurred a rally along with a sharp depreciation of the yen after announcing a large stimulus program.

The "long the Nikkei, short the yen" trade has been one of the most rewarding trades among hedge fund managers since the beginning of the year, according to news reports.

"Some might think that getting into the game now is not the best time because the rally is already priced in," Zayed said.

"Others may think we've not seen these levels in three years and that the Nikkei is probably going to reach new highs in 14 months.

"Obviously it all depends on your outlook. If you're mildly bullish, no doubt this is the right play. If you're ultra-bullish, you're not going to do it because of the cap.

"I like the duration. The leverage is phenomenal. It's a personal preference. It's a particular risk profile on a tactical play."

But the Nikkei was not his underlying of choice.

"The Nikkei had an interesting history over the past 20 years. Caution is warranted with Japan," he said.

His main concern was the risk versus reward of the notes given the moderately bullish view suggested by the low cap and the unlimited downside risk.

"It only requires 4% growth to reach the cap. That's a very specific return expectation on the index," he said.

"I personally wouldn't do it. It's too confining in terms of the expectation of return and the timing."

Zayed said that he did not object to the structure. Instead, the risk lied with the recent highs of the index, which some already see as a sign that the rally may be near its end.

"I have nothing against leveraged notes with no downside protection. I'm not opposed to that structure if it's with another underlying," he said.

Up to the cap

Jonathan Tiemann, president and chief investment officer at Tiemann Investment Advisors, LLC, said that the notes made sense for moderately bullish investors as long as the final return stayed within a range.

"It's a funny trade because you only come out ahead if your final return is up to the cap," he said.

"For instance, if the cap is 14%, if it goes up 10%, you don't get three times 10%, but you do get 14% and you're still better off than 10%. On the other hand, if the underlying goes up by 20%, you'd rather be just long the index. But up to slightly less than 14% you're still doing better. Even though you don't get three times, the cap is still better than one time."

Tiemann said that investors had to have limited bullish expectations and also a very specific view on the timing of the rally.

"You think that the index could be going up a bit further but not that much further," he said.

"The buyer thinks the rally is almost but not quite played out. It's not going to turn around any time soon.

"I suppose you can buy this thing and short the underlying somewhat as a hedge."

Without a hedge, the trade was risky due to the relative lack of liquidity associated with structured notes, he said.

"If the index starts dropping, you're stuck with this thing for 14 months. It's hard to close out the trade before the end of the term. The prospectus always says that you may not find a market to sell the notes on the secondary market. I think they say that for a reason," he said.

One advantage of the product compared to a liquid instrument such as an exchange-traded fund was the asymmetrical leverage: investors in the notes only get one-to-one exposure to the index on the downside, while equity investors would get a three-to-one leveraged exposure on the downside in the same way as in the upside.

"But you pay for that with the cap," he said.

Covered call

One way to replicate the trade with more liquidity was to use options, Tiemann said.

"I guess you are long the underlying, plus you are long two at-the-money calls. In addition, you sell three calls with a strike that's at the cap level," he said.

"If the underlying goes down, you lose on the underlying long position and the two calls expire worthless. That's the one-to-one exposure on the downside.

"If the underlying is up 3%, the underlying goes up and your two calls go up too. You get the three times.

"To pay for the two calls, you sell three calls at the cap strike.

"Overall, you are long the underlying; you are long two calls at the money; you are short three calls at the cap.

"It's sort of like a covered call writing strategy, but instead of selling off your upside for cash, you're selling off your upside for the sake of leverage exposure."

Downside risk

Tiemann said that having exposure to the downside with no protection was acceptable when one was long a security that offers full liquidity.

"I buy investments without downside protection all the time, but they are simply long positions," he said.

"If you own the thing, you have the downside risk.

"I'm sympathetic with the view shared by some people who would say 'What's the point of buying structured notes if you don't have downside protection?'"

Tiemann said that he has no particular view on Japan even if current market conditions may justify the bullish tide.

"It looks like the G20 has given Japan a pass on its currency weakening efforts, and that's generally supportive for stocks."

The notes are expected to price and settle in February.

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