HSBC's buffered notes linked to Dow offer 100% upside participation with no cap for growth

By Emma Trincal

New York, April 12 - HSBC USA Inc.'s 0% buffered uncapped market participation securities due April 28, 2016 linked to the Dow Jones industrial average are designed for cautiously bullish investors who are willing to hold the notes for three years in exchange for unlimited upside and partial downside protection, said Suzi Hampson, structured products analyst at Future Value Consultants.

If the index return is positive, the payout at maturity will be par plus the index return, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by up to the buffer amount and will lose 1% for every 1% that the index declines beyond the buffer. The buffer amount is expected to be 15% to 20% and will be set at pricing.

"This product is designed for investors who are sufficiently bullish to find more value in the absence of a cap than leverage," she said.

"At the same, they are cautiously bullish and they like the buffer. This buffer is defined in a range. We don't see that often. We've based our report halfway, setting a hypothetical 17.5% buffer halfway in the 15%-20% range."

Different proposition

Investors may also use the notes as an alternative to a direct equity investment.

"It could be some sort of equity Dow Jones substitute to an ETF or U.S. equity fund. It would be a good fit for that part of a portfolio," she said.

"One of the advantages of structured products is that you can have the downside protection. You give up dividends; that's how you pay for it. This one, however, doesn't put you in the situation of giving up any upside, which is attractive. There's no cap.

"Compared to an ETF investment, you are reallocating risk on a three-year period. You forego the dividends and get credit risk exposure. In exchange, you're getting the full upside plus a buffer. It's a slightly different risk return proposition."

With the Dow yield at roughly 2.5%, investors over the three-year term of the notes would be giving up about 7.5% in dividend returns, she noted. This amount would represent half of the lower end of the buffer range, she added.

"You're getting more in buffer than you're losing in dividends, but that's because the issuer needs to compensate you for having to hold the investment for three years and for the credit risk exposure," she said.

"We're dealing with a slightly more cautious investor who wants exposure to the index.

"The combination of the 15% buffer and the one-to-one upside participation allows you to still outperform [if] the index is down.

"This is for an investor who wants to get the equity exposure but change the risk parameters as well."

Riskmap

One way to do that, she said, is to decide which type of risk the investor wants to reduce his exposure to.

Future Value Consultants rates the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

"The notes, according to our scores, appear better suited for an investor who would be interested in minimizing credit risk," she said.

The riskmap of the product is about the same as the average for the same product type, she said. Products in the same category are unleveraged return notes. The notes have a 2.70 riskmap versus an average 2.69 riskmap for the same product type.

But the risk components vary.

"The 0.55 credit risk is not bad at all. It's not standing out as a problem. It compares quite well with the 0.70 average credit risk for the same product type. This suggests a good credit issuer.

"The market risk, however, is slightly higher than average."

The market riskmap is 2.16 versus 1.99 for the average in the same category.

"This difference could be due to the fact that most of these products are linked to the S&P 500. Also this one may be a little bit longer," she said.

"A 15% to 20% buffer sounds quite generous, but over a three-year period, it might not be as good as a 10% buffer on a one-year for instance.

"The maturity has a big impact on this product.

"So we can see that despite a riskmap that's average, the two risk components here split quite differently.

"If credit risk is something you want to get to a minimum, this might be more interesting. You still have the market risk, but if your priority is to limit your credit risk exposure, then maybe this is the risk level you would want to be looking at."

Risk-adjusted return

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The product showed an 8.15 return score, compared with 7.44 for the average of the same product type.

"The return score is a risk-adjusted metrics that takes into account the riskmap and compares it against the return. It's based on the best market assumption as opposed to the riskmap, which is based on the neutral, or risk-free scenario," she said.

The best scenario in this case would be a bull market.

"We have a three-year product with an uncapped return. In a bull market, the risk will be reduced considerably as prices will be moving up. Because the return is uncapped and you have three years to generate the gains, the structure would have the potential to provide very good returns," she said.

"Uncapped notes as a category do seem to score very well on the return scale, especially for longer-term products where you have the potential to compound more gains. A one-year maturity would not give the underlying such a good opportunity to grow while on a three-year, returns can be quite high."

Price, overall

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 via its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score for the notes at 8.16 is higher than the 7.81 average score for the product type.

"The price score is high," she said. "It indicates good value.

"Unleveraged return notes represent a good scoring kind of product type even if some of them end up scoring better than others.

"Part of it is because they tend to be longer-term products with uncapped return potential. The product type is also quite common and issuers often use relatively common indexes. It's quite competitive. Issuers have an incentive to price it well.

"With low interest rates, it's not necessarily easy to price a product with 100% upside participation and no cap. Most of the time, the easiest way to do it is to extend the maturity. Imagine a similar product with a one-year tenor. Your notes most likely would have to be capped."

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

At 8.16, the product's overall score is much higher than the 7.63 average for the same category, she noted.

"It has an impressive overall score," she said.

"It's quite consistent with the two other scores. Sometimes you have a great price score with an average return rating, or the opposite. But here, the notes offer above-average scores for both return and price.

"The potential return is better than average; the value for your money is also better than average; and the risk is average. So your overall score is going to be good.

"As long as investors are prepared to hold the notes to maturity, they can expect potential great returns with the downside protection."

The notes (Cusip: 40432XDK4) will price on April 25 and settle on April 30.

HSBC Securities (USA) Inc. is the underwriter.

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