HSBC's $8.01 million trigger participation notes tied to S&P 500 have new 'conversion' feature

By Emma Trincal

New York, April 3 - HSBC USA Inc.'s $8.01 million of 0% trigger participation notes due March 3, 2017 linked to the S&P 500 index offer a feature sources said has not been seen in the United States or rarely. The technique may appeal to investors seeking protection beyond the boundaries of a traditional downside trigger.

"We've priced something like that in the past. I can't remember exactly if we ended up doing it," a sellsider said.

"I don't think it has been done a lot in the U.S. In fact, this could actually be the first," he added.

If the final index level is greater than the initial index level, the payout at maturity will be par of $10 plus the index return, according to a 424B2 filing with the Securities and Exchange Commission.

If the final index level is less than or equal to initial index level and greater than or equal to the trigger level, 90% of the initial index level, the payout will be par.

If the final index level is less than the trigger level and a conversion event has occurred, the payout will be par. A conversion event will occur if the index closes at or above the conversion level, 115% of the initial index level, on any day during the life of the notes.

If the final index level is less than the trigger level and a conversion event has not occurred, investors will lose 1% for every 1% that the final index level is less than the initial index level.

"It's eye-catching, that's the first impression. We may see more of it. We'll see if a lot of people copycat it," said Steve Doucette, financial adviser at Proctor Financial.

'Sleep better at night'

The sellsider explained the benefits of the "conversion" feature by comparing the notes' payout to a direct investment in the index. He did not take into account the non-dividend payment.

"Am I better off with this note than with a long-only investment in the S&P? If you forget about dividends, actually it's not bad," he said.

"On the upside, I'm doing the same as the index.

"On the downside, regardless of this conversion feature, I do have this 10% contingent protection. It means that compared to a direct investment in the index, I'm already better off because I have a little bit of downside protection.

"On top of that, they throw another feature, this conversion option, which is not likely to be exercised, but then again, it may.

"If the index is up in the next two years and the market corrects at the end, I would want to have this feature in my note.

"If the market is up, I'll do well in any case, and I can sleep better at night."

Limited alpha

But for Doucette, while the notes offer market exposure, they are not necessarily a source of alpha.

"This is a pretty intriguing note. On the one hand, it's a pretty generic note with a 90% barrier and you're straight long the index," he said.

"But you can outperform on the downside if you reach that 115% level anytime. Suppose that you don't, though. Imagine the market never gets to plus 15%. In that case, the only way you can outperform the downside is if the market is down but not by more than 10%. That's a pretty narrow range. Otherwise, you're just long the index up and down. This feature only locks in a protection. It does nothing to enhance the upside.

"Now suppose the 15% conversion event is triggered. In order to outperform the market, the index would have to go up by 15% and then down by more than 10%.

"I'd have to look at the pricing and see what trade-off I'm getting. Is this protection cheap? How much is that optionality component, and what am I giving up to have it?"

Insurance

"I guess you could say that you're long the index and that you can have that protection level if things get ugly. That 15% knock-out is a cool feature. But the only way it's going to pay is if things after a rising market get extremely ugly. If you have a big correction after a 15% upward move, then yes, you would get a lot out of it with a protection all the way down," he said.

"It's some form of insurance, and I assume it's pretty expensive insurance. But I'm not sure really. I would have to look at it more closely."

Doucette conceded that anyone seeking insurance would be better off buying it now as the market is still going up than after a sell-off.

"But I'm still unsure about the value of this feature because you could very well end up not having any use for this protection at all. If the market is up 15%, wouldn't you be better off being long the index? Should you be concerned about downside protection in that type of scenario?

"I would really need to evaluate it more. And that would mean looking at the pricing."

Pricing

The conversion feature, according to the sellsider, "probably doesn't cost a lot" because options are priced based on probabilities.

"What are the odds the market would go up 15% and then down by more than 10%? That's a 25% move. It's not impossible, but the likelihood is not high. If the probability is not that high, the option is not going to be very expensive," he said.

"So basically this is adding more bells and whistles. It doesn't cost that much, but it provides some differential. It's a nice feature to have.

"If the market goes up, you participate and you feel much safer.

"My take is that without this feature you probably could have an 85% barrier instead of 90% or even maybe 80%.

"As long as you feel that you're not giving up too much to get this feature, why not?"

A market participant decomposed the structure as follow: Investors are long a zero-coupon note for the full downside protection. In addition, they are long an at-the-money call since the payoff is based on the initial price. The long call position gives the one-to-one upside participation. Finally, investors are short an at-the-money put with a knock-out observed daily at 115. If it reaches 115, the put is knocked out. It doesn't exist anymore. The knock-in barrier is at 90 and is only observed at maturity.

What's next?

Sources agreed that the conversion feature is relatively new.

"The barrier technology is not new, but I don't think I've seen it for U.S. retail," the market participant said.

But whether the technique will be copied will depend on how investors react to it.

"As with any product, the issuer always has to strike the right balance between simplicity and innovation," the sellsider said.

"New bells and whistles are nice to have. They add value to the product, but when they do, it's a little bit harder to explain things to the investor. Sometimes investors react enthusiastically. Sometimes they don't.

"We on the structuring side like to come up with new ideas. But at the end of the day, the investor has to make the decision whether this is something that they like.

"It's a process. Issuers try new things, and investors exercise their judgment.

"If you see more volume for these types of deals, you'll see copycats right away. After all, this is a fairly easy structure to price."

The notes (Cusip: 40434C857) priced March 31.

The fee was 2.5%.

HSBC Securities (USA) Inc. was the agent with distribution through Morgan Stanley Wealth Management.

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