HSBC's 50/150 performance securities tied to S&P 500 Low Volatility seen as 'flexible'

By Emma Trincal

New York, Feb. 28 - HSBC USA Inc.'s 0% 50/150 performance securities due Sept. 28, 2018 linked to the S&P 500 Low Volatility index give a wide variety of investors the opportunity to express their views on the market through the use of an uncommon downside protection feature combined with a low volatility underlier, sources said.

The S&P 500 Low Volatility index comprises the 100 least-volatile stocks over the previous year in the S&P 500 index

New twist

The term 50/150 performance securities describes the participation rates offered by the structure: on the downside, investors may lose 0.5% of their investment for every 1% decline in the index from the initial price.

As a result, they are exposed to 50% of index losses, according to an FWP filing with the Securities and Exchange Commission.

On the upside, they may realize 150% of the index appreciation.

For Steve Doucette, financial adviser at Proctor Financial, this "unusual" structure and the nature of the index being used in the notes offered many possibilities to investors.

"It's a new twist," he said.

"It gives you participation in the downside but with a maximum 50% loss.

"None of the notes that we typically see provide that kind of downside protection unless you give up all or a good chunk of the upside."

Part of the tradeoff investors had to agree to in order to benefit from the "generous" downside protection was the longer maturity, he said. But at least they were not penalized on the upside, which made the product very different from other notes, he added.

"The risk reward is interesting because usually, if you want leverage without a cap, you have to start taking the amplified exposure on the downside beyond the buffer," he said.

"It's perfect for someone who is willing to hold this for five and a half years."

"If you consider the return characteristics of this index relative to the S&P, the fact that you're long 150% of the upside without the cap, it's very attractive," said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

Dialing the desk

"I would be curious to know how you could play with those parameters, how you can readjust the downside and the upside in ways that can fit your own view on the market," Doucette said.

"For instance if you're more bullish, you may be willing to take 75% participation in the downside for more upside, like two times up for instance. That's just one example. I don't know if you would be 1.75, 2 or 2.25 for the upside multiple. You'd have to do the math with these guys on the desks and you would have to know what your investment goal is. But I bet it would be very interesting," he added.

"Alternatively, if you're more bearish you may be willing to get only one-for-one on the upside in order to lose only 25% of the downside.

As is, the notes can be of interest to different types of investors.

"If you're bullish, you like the leverage and the uncapped return; if you're bearish, you like the downside protection," he said.

"It's sort of flexible.

"But nothing stops you from calling up the issuer and have them fine-tune the payout. It would open the door to new possibilities.

"I am a semi-bullish guy... My take is that we're going into what I think is a momentum play. To me if the market goes up 25% more, getting 100% to 110% upside and more protection on the downside may be worthwhile."

The use of the S&P 500 Low Volatility index as the underlying asset offers additional opportunities in terms of hedging the market or minimizing its widest moves, the financial advisers said.

Tempering the market

A performance table in the prospectus showed that the S&P 500 Low Volatility tends to underperform the S&P 500 in bull markets but that it outperforms the benchmark in down markets.

In strong bull markets, the S&P 500 tends to significantly outperform the S&P 500 Low Volatility index although they usually continue to move in the same direction, according to the table.

For instance, in 2009, the S&P 500 gained 23.45% while the S&P 500 Low Volatility index rose by 15.55%.

In some bull market scenarios, however, the correlation between the two indexes may be inverted. In 1999 for instance, the S&P finished up 19.53% while the Low Volatility index lost 10.72%.

In strong bear markets, the S&P Low Volatility index significantly outperforms the market. In 2008, for instance, the S&P 500 Low Volatility index moved in the same directions as the market but outperformed the S&P 500, losing 23.61% instead of the 38.49% decline seen in the S&P 500.

When the market lost 10% in 2000, the Low Volatility index was up 20.68%.

"In extreme markets, the S&P Low vol. is inversely correlated to the S&P," Doucette said.

"If you buy this, you probably like the inverse relationship while you're also trying to temper it.

"You need to figure out how this inverse relationship is playing out in your portfolio.

"For instance in 2012, the low vol. index was up 6% versus a 13% gain in the S&P 500. With this note, you get 9% instead of 13% but a lot of people would be happy with 9%.

"It's when it's negative that you have to be tempering that drag.

"You can have a bear market on the S&P and still lose on the low vol., but you're going to lose less," he said referring to declines seen in 2008, saying that investors in the notes would have lost only 12% during that year, which is more than three times less the S&P 500.

"That's what I mean by tempering."

Plot the exposure

The exposure to the S&P 500 Low Volatility index required that investors had a clear market outlook and strategy, Doucette said.

"You're not long this index the way you would be long the S&P," he said.

"In fact, I would really like to see that structure on the S&P 500, obviously. But this is a different index. It's a different strategy.

"You plot your exposure on the S&P against your exposure on this note and see.

"You're looking to temper the volatility of the S&P. At the same time, you don't want to be underperforming too much when the S&P does well, and that's a risk you're trying to take off the table as well.

"You're not just investing in the Low Vol index. You're also buying futures in the S&P.

"The trader on the desk has to have some level of S&P exposure in order to provide you with these wide ranges of protection and leverage," Doucette said.

Macro view

Medeiros said that investors should allocate between the S&P 500 and the S&P 500 Low Volatility index based on their market views. But the five-and-a half year tenor was a drawback.

"It's quite long. It's a very interesting structure but I'm a little concerned with the long maturity," he said.

"I don't see much of a scenario when we're going to have a raging bull market in the S&P. I'm more concerned with the risk.

"I like it more for the short-term. If I compare the S&P 500 with the S&P Low Volatility, I think I'm more comfortable with the Low Volatility index right now. Being long 150% of this index makes it all the more attractive.

"However, once you pass the next 24 months it becomes a gray area. Which one between the two indexes makes the more sense five years from now? I'm not sure.

"If somebody is more optimistic about the S&P 500, it may be wiser to hold the real index as a core holding and use the S&P Low Volatility index as a satellite allocation, something you can play opportunistically.

"Personally, I'm not optimistic for the 24 to 60 months looking forward. So it may make sense to use this note as a core, and trade the regular index.

"It's a neat idea for somebody who says: 'I need to participate in the market but I'm still very nervous.

"When you look at the S&P last year, you have nice returns, but 90% of it came from the top 10 companies. It makes me a little bit nervous to know that 50% of these 10 stocks were financials. This doesn't really indicate global optimism.

"You need to view these two indexes independently for their respective risk-return characteristics and see which one matches your macro view of the market.

"That note is not for everyone," he said.

HSBC Securities (USA) Inc. is the agent.

The securities will price on March 25 and settle on March 28.

The Cusip number is 40432XC66.

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