HSBC's autocallable notes on Energy SPDR offer potential early return, partial protection

By Emma Trincal

New York, May 24 - Investors looking for exposure to the energy sector and seeking a potentially high payout over a short period of time, possibly through an early redemption, may consider HSBC USA Inc.'s planned autocallable optimization notes linked to the Energy Select Sector SPDR exchange-traded fund, sources said.

However, investors should be aware of the limits of the investment as their principal is not fully guaranteed and returns, if any, are capped.

HSBC plans to price 0% autocallable optimization securities with contingent protection due June 1, 2011 based on the performance of the Energy Select Sector SPDR fund, according to an FWP filing with the Securities and Exchange Commission.

If the fund closes above its initial share price on any of the 12 monthly observation dates, the notes will be called and investors will receive par of $10 plus an annualized return of 18.5% to 23.5%, with the exact percentage to be set at pricing.

The payout at maturity will be par if the final share price is at least 75% of the initial price. Otherwise, investors will receive par plus the share price return.

Know thy investment

"It's an interesting product. I can see why people would be seduced by it. If it gets called, you get an above-average return," said Scott Rothbort, founder of Lakeview Asset Management.

"It's a different risk/reward than investing directly in the fund. It's not necessarily good or bad. It depends on the individual. It's the type of product you have to look at on a case-per-case basis," he said.

Rothbort warned that the notes are not for everyone.

"I have invested in similar types of products from time to time. A professional money manager would understand how to value them more than a retail investor. If you know what you're doing, that's fine. But if you don't, you could get hurt."

Tactical opportunity

The notes offer a tactical investment opportunity, according to the prospectus. The securities would appeal to mildly bullish investors in energy who would not know when to time the appreciation of the fund during the 12 months, but who want to get an opportunity to generate an annualized return of approximately 20% if the fund increases during any one of the 12 evaluation dates scheduled on a specific day of each month, according to the prospectus.

If the notes are not called, investors have downside exposure. But the contingent protection provides for a full protection of their principal as long as the fund ends above the trigger price, which is 75% of the initial price, according to the prospectus. For instance, a decline of 24% of the share price at maturity would not cause any loss of principal for investors.

Risk is risk

But a market participant said that the notes remain risky.

"Risk is risk. You either have risk or you don't. You can still lose 100% of your principal," he said. "Personally, I'd rather minimize the risk and have a lower return. If I want risk, I invest in the equity directly."

Acknowledging that the notes offered a different risk/reward profile than a direct investment in the shares, he said, "As long as investors understand that more risk is what gives you a higher potential return, and that you get less return when you minimize risk, if they can really see both sides and if they're willing to take the risk, then it makes sense."

Good alternative

Kirk Chisholm, principal and wealth manager at NUA Advisors, said that the securities were a good fit for investors who predicted limited gains in the energy sector over the next 12 months as a result of their macroeconomic view.

"I wouldn't invest in commodities now because I see deflation as the fundamental problem coming up, not inflation. But if I had to have an allocation to energy, then these notes would be a good alternative to the ETF," he said.

"If you don't see the energy sector growing in excess of 20% a year from now, then these notes are a good fit because you get a potential upside of 20% with principal protection for up to a 25% decline. It does make sense," said Chisholm.

"For instance if energy is down 24%, you get your principal back. And if it's up by 5%, you get 20%. If you don't see massive inflation ahead and therefore if you don't anticipate an overwhelming upside for the fund, then from that perspective, the notes are reasonable," he added.

Value investing

"A lot of people are negative on oil right now because of the oil spill. But a lot of the negative news has already priced in," said Chisholm.

The Energy Select Sector SPDR fund seeks to provide investment results that correspond to the price and yield performance of the Energy Select Sector of the S&P 500 index. Energy companies in this index primarily develop and produce crude oil and natural gas and provide drilling and other energy-related services. Some of the leading names in the group include Exxon Mobil Corp., Chevron Corp. and ConocoPhillips.

Shares of the ETF closed at $51.86 on Monday, down nearly 12% this year. However, the fund was up 14% in 2009 and finished 4.5% higher in the past 12 months.

"We like crude oil right now, and we're mildly bullish at these levels," said Matthew Bradbard, president of MB Wealth.

Crude oil for July delivery settled at $70.21 a barrel on the New York Mercantile Exchange Monday. Prices have fallen by 12% this year but are nearly 15% higher than a year ago.

"We're nibbling at these levels," Bradbard said.

He added that he liked the Energy Select Sector SPDR fund, although he is not an equity investor. "Most of the ETF is heavily weighted on oil," he said.

Not for bulls

But Bradbard, who is a commodity trader and who prefers direct and diversified commodity investments through options and futures, said that the structure of the notes did not fit his highly bullish profile.

"I'm capped at 20%. I have unlimited downside. And I'm tied to one thing. That's not my risk profile. If I put one dollar somewhere, I want to make two or three," he said.

The notes are expected to price on Tuesday and settle on Friday.

UBS Financial Services Inc. and HSBC USA Inc. are the agents.

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