HSBC's leveraged notes on oil and gas stocks are for mild bulls with shale sector focus

By Emma Trincal

New York, Dec. 5 - HSBC USA Inc.'s 0% buffered return optimization securities due Dec. 22, 2014 linked to a basket of shale oil and gas stocks are designed for investors moderately bullish on oil and gas but seeking to focus on a specific segment of this market, said structured products analyst Suzi Hampson at Future Value Consultants.

The basket includes equal weights of the stocks of Consol Energy Inc., Devon Energy Corp., Encana Corp., Newfield Exploration Co., Range Resources Corp. and Southwestern Energy Co., according to an FWP filing with the Securities and Exchange Commission.

All those companies have North American shale acreage holdings, according to the prospectus.

The payout at maturity will be par plus triple any gain in the basket, up to a maximum gain of 38% to 43%. The exact maximum return will be set at pricing.

Investors will receive par if the basket falls by up to 20% and will lose 1% for every 1% decline in the basket beyond 20%.

Bulls with a focus

Hampson said that the notes are aimed at investors who expect small to moderate returns in the underlying basket.

With a 38% to 43% cap over the three-year term, investors do not expect an annual growth of more than 12.67% to 14.33% per year.

Since the structure leverages up the basket return by a factor of three, it only takes an annual growth of approximately 4.5% in the basket for investors to maximize their gains.

"It doesn't take much growth to hit your target return," she said.

"If you were really bullish on those stocks, why would you want the return to be capped? This is for investors who don't anticipate a lot of growth. They're moderately bullish.

"More importantly, this product targets people who are looking for a specific theme, which here is the shale oil and gas sector," she said.

Shale oil is a substitute for conventional crude oil and is extracted from unconventional sources such as shale beds and oil sands.

"A basket of stocks rather than a broad index is ideal for those who want to target a specific investment theme.

"It's a cheaper and much easier way to get exposure to the sector than buying the stocks yourself.

"And a commodity index or even an oil index wouldn't give you the same access to a niche market," she said.

Three-year, 20% buffer

In addition to its underlying, the product offered some characteristics that are not common among other leveraged return notes, she said, citing the tenor and the buffer.

"We don't see that many three-year leveraged return products. It's typically one year to 18 months," she said.

"A 20% buffer is also unusual. But it's quite logical: the longer the product, the bigger the buffer.

"As with all leveraged return notes, investors buy those products rather than the underlying index or basket to change the risk return profile. They get some leverage on the upside, some protection on the downside. The price to pay for that is the cap.

"With this one, investors have to be prepared to hold the notes for three years and to tolerate the cap.

"If they're happy with 12% a year, it only requires a 4% growth a year, then they have a chance to meet their target return.

"A 300% participation rate is quite a lot of leverage. A more bullish type of investor would go for less gearing and a higher cap or no cap at all," she said.

Average risk

The risk associated with the product as reflected by the riskmap - a Future Value Consultants score that measures the risk on a scale of zero to 10 - was standard, with a 4.68 riskmap. It is about the same as the average of similar products, which include all leveraged products with or without downside protection and of various tenors.

"It's an average risk for this kind of product type," said Hampson.

In comparison to all products recently rated by Future Value Consultants, with a 5.18 riskmap, this one was moderate, she said.

Other products include reverse convertibles, which increase the overall riskmap of the group.

The riskmap is the sum of two risk components: market risk and credit risk.

As credit risk increases with the duration, this product showed a higher credit riskmap at 1.03 than its peers (0.69) and even greater than all products (0.54), she noted.

The market riskmap, however, which is 3.66, is much lower than the average market riskmap of the same type of products, which is 4 and even much lower than all products, with those scoring 4.64 on the same zero to 10 scale.

"There is less market risk here because of the 20% buffer. When compared to other leveraged notes, you're comparing it to products that have smaller buffers, barriers rather than buffers or even no downside protection at all," said Hampson.

Fair return

Future Value's opinion of the risk-adjusted return is measured on a scale of zero to 10 by the return score.

In the calculation of the return score, Future Value Consultants use five key assumptions - neutral assumption, high and low growth environments, and high and low volatility environments. The firm calculates a risk-adjusted average return for each assumption. The return score is the best of these five returns.

The average return score for all products is 6.26. Leveraged return notes as a group show a higher return score of 7.09. This product is slightly above the average of its peers with a 7.14 score.

"It's clearly correlated to the low risk," said Hampson.

"This product offers a fair return that's in line with the rest of the products in the same group.

"In general, leveraged return scores better on the return scale than all products," she said.

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.

The performance is modeled based on a series of parameters, which include for instance among others, volatility, dividends and interest rates.

The probability table for this product shows a 37.8% chance of getting a positive return of 10% to 15% per annum. The odds of losing more than 15% of principal are 15.4%.

Due to the cap, investors may not earn more than 15% per annum. On the other hand, they have a 5.2% chance of earning between 5% and 10% per year and their probability of generating a gain of less than 5% annually is 17.2%.

Price, overall

The price score represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis and profit margins on the underlying derivative.

Calculated on a scale of zero to 10, the price score for this product is "high," said Hampson at 8.06.

"It's a very good price score, higher than similar products. It means that the options price is of good value to the investor," she said.

The price score for similar products and all products is 6.42 and 7.17, respectively.

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.

The product received an overall score of 7.60, slightly better than the 7.13 average score for the products of the same type and definitely better than 6.34, the score for all products.

"The high price score and decent return score have pulled up the overall to a pretty good level," said Hampson.

The notes (Cusip: 40433K876) will price Dec. 16 and settle Dec. 21.

HSBC Securities (USA) Inc. will be the underwriter, and UBS Financial Services Inc. will be the agent.

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