HSBC's notes linked to S&P 500 Low Volatility index tap into increasingly popular strategy

By Emma Trincal

New York, May 29 - HSBC USA Inc.'s 0% Leveraged Index Return Notes due June 2014 linked to the S&P 500 Low Volatility index offer investors leveraged exposure to an increasingly popular benchmark, sources said.

The payout at maturity will be par of $10 plus 135% to 155% of any index gain. The exact participation rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will be exposed to any index decline.

Bank of America Merrill Lynch is the agent.

The index consists of the 100 stocks from the S&P 500 index with the lowest realized volatility over the past 12 months.

A 'revolution'

"The low-volatility strategy has become hugely popular among clients," said Bill Thatcher, principal at Mercer Investments.

"It's a conceptual revolution. It runs counter to the intuitive notion that the more risk you take, the more return you'll get."

Alka Banerjee, vice president of global equity and strategy indexes at Standard & Poor's, whose team created the index in April 2011, said that the benchmark was designed in response to a growing number of client inquiries expressing interest in the concept of yielding more from less risk.

"The strategy derives from academic research that shows that low-volatility stocks have outperformed high-volatility stocks in the U.S. markets over time," Banerjee said.

"We had some market feedback indicating a solid interest for that strategy after the heavy losses of 2008. Since the 2008 financial crisis, there has been a more pronounced consciousness about market risk. People have said 'I can't afford to lose 50% of my assets anymore.'

"If you go back a number of years, you'll see that these low-volatility stocks do much better in bear markets than the average S&P," Thatcher said.

"People are starting to look into that. I know that at Mercer, we kind of like low-volatility strategies," he added.

Banerjee said that there is currently no exchange-traded fund that offers a leveraged exposure to the index.

However, the S&P 500 Low Volatility Portfolio ETF tracks the S&P 500 Low Volatility index on a non-leveraged basis. It is listed on the NYSE Arca under the symbol "SPLV."

Dividend deprivation

Thatcher said that low-volatility investing offers parallels with high-yield equity strategies.

"These less volatile stocks tend to have higher dividends," he said.

"People like high-dividend stocks. Here is something that has a higher yield than the S&P 500, and it also yields better than a corporate 10-year bond."

One big difference between the notes and the ETF, however, is dividends, which represent a current yield of more than 3% for the ETF and nothing for the notes.

"You're taking away the dividend benefit. That's a big part of the dividend sales that you're removing here," Thatcher said.

On the other hand, the notes give investors the upside leverage.

"This note could be used as an alternative to the ETF with the added benefit of leverage," Thatcher said.

"But you pay for that by taking on credit risk and giving up dividends and liquidity. You have to decide if it's worth taking on these additional risks."

Michael Iver, founder of iVerit, observed that the dividends are used by the issuer to pay for the leverage feature.

"That is the bet: forgo dividends and what you would earn lending the issuer money - in other words, Treasury rates plus CDS spread - and get leverage in return," Iver said.

Buyout substitute

The notes could also be used as an alternative to a type of private equity investing popular among institutional investors, said Thatcher.

"Buyout funds purchase low-volatility stocks, they use leverage, turn the companies around and take them private," he said.

"Those guys are smart. They only target companies with beta of 0.7 or 0.8 because they are using leverage with caution. They don't want to get downside leverage with high-volatility stocks. The idea is that the operational restructuring, the turnaround, management changes are going to generate alpha.

"This structured product reflects something similar to this: getting leveraged exposure to a portfolio of low-volatility stocks. In fact, I see these notes almost as an index version of a buyout fund."

Not only do the notes offer some similarities, they may also have their own benefits, he added.

"You get better liquidity. It's a two-year portfolio versus a 10-year lock up," Thatcher said.

"The upside on your note return is leveraged, but it's asymmetrical leverage. You don't get the downside leverage while you get leverage on both sides with the buyout fund.

"I see these notes as a possible alternative to buyout funds, especially if you're skeptical about the alpha produced by the operational turnaround in a buyout fund."

According to data compiled by Prospect News, only HSBC has issued notes linked to the S&P 500 Low Volatility index since the creation of the benchmark. So far, 18 HSBC deals have priced totaling $20 million. Standard & Poor's did not comment on its licensees.

The notes will price in June and settle in July.

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