HSBC phoenix autocallables tied to Russell 2000 ETF offer decent barrier, risk of high losses

By Emma Trincal

New York, Oct. 6 - HSBC USA Inc.'s upcoming trigger phoenix autocallable optimization securities due Oct. 19, 2012 linked to the iShares Russell 2000 index fund present a risk of losses that is moderate given the protection amount but one that investors may not be willing to take in today's market, sources said.

The notes pay a contingent coupon of 13% to 17% if on a quarterly observation date the exchange-traded fund's shares close at or above the trigger price - 65% of the initial share price, according to an FWP filing with the Securities and Exchange Commission.

The exact coupon rate will be set at pricing.

If the shares close at or above the initial price on a quarterly observation date, the notes will be called at par of $10 plus the contingent coupon.

If the notes are not called and the shares finish at or above the trigger price, the payout at maturity will be par plus the contingent coupon. Otherwise, investors will be exposed to the share price decline from the initial price.

Reasonable cushion

"Thirty five percent is a reasonable downside from where we are now," said Steve Doucette, financial adviser at Proctor Financial.

The ETF, which tracks the U.S. small cap universe by replicating the performance of the Russell 2000 index, is down 15% this year. It has underperformed the S&P 500, which has lost 8%.

In general, Doucette said that "it doesn't make sense to substitute a fixed-income return for a 100% exposure on the downside because the risk/return is too great."

If the 65% trigger price is hit at maturity, investors do not benefit from any buffer or protection and can lose their entire principal, he said.

"However, the 35% protection gives you a reasonable level of comfort before you start losing anything.

"The idea with these phoenix notes - and we see a lot of them - is that you can collect your coupon several times even if the market is still down," he said.

"Given the current level of the index, it would take a lot to hit the 35% trigger at maturity. So I guess it's a reasonable risk/return. For some people, the assumption is that it's not going to happen."

Too short

But Doucette said that he would not take the risk given the short duration of the notes.

"If we go into another recession, who is to say we won't breach that barrier a year from now? Is one year enough to mitigate that risk? I'm not sure. It's probably too short. It may not be enough time for the market to come back," he said.

For Matt Medeiros, president and chief executive of the Institute for Wealth Management, the key concern is not so much the duration of the notes but the underlying fund itself, which he doubts may be a good performer in today's economy.

"The risk of losing capital is moderate with 35%, so yes, they set up parameters that make it of interest," he said.

Recession risk

"But in this environment, I'm not sure that small caps are going to perform well given the job situation and the economy. I'm concerned that you're going to participate in the market downside," he said.

Another risk for investors is that they may never earn any income, he said. That's because the payment of the coupon is contingent upon the ETF price closing above the coupon barrier on any of the four observation dates.

Meanwhile, if the ETF hits the trigger price at maturity, the potential for losses is unlimited, he noted.

"People are risk averse at this point, and while 35% is a moderate risk, it's still a risk," he said.

"I wouldn't take that risk in the small cap space, at least not at this time."

The notes (Cusip: 40433C346) are expected to price Oct. 14 and settle Oct. 19.

HSBC Securities (USA) Inc. is the underwriter with UBS Financial Services Inc. as dealer.

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