HSBC's 50/150 performance notes tied to S&P 500 Low Volatility aimed at risk-averse investors

By Emma Trincal

New York, Feb. 6 - HSBC USA Inc.'s 0% 50/150 performance notes due March 1, 2017 linked to the S&P 500 Low Volatility index are sure to appeal to conservative investors seeking enhanced return, sources said.

"You already take a conservative underlying - a low-volatility equity index - and you get more upside than the standard index and half of the downside. It's conservative on top of being conservative," said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

The product combines the use of a relatively new low-beta index as the underlying with a structure that offers a 1.5 times leverage factor on the upside and a 0.5 times leverage factor on the downside, according to an FWP filing with the Securities and Exchange Commission.

The S&P 500 Low Volatility index is made up of the 100 least-volatile stocks over the previous year in the S&P 500 index.

If the index return is greater than or equal to zero, the payout at maturity will be par plus 1.5% for every 1% that the index increases. If the index return is less than zero, the payout will be par minus 0.5% for every 1% that the index declines.

Rare protection

Sources said that the unusual 50% downside participation provides an attractive mechanism for risk mitigation.

"It's a dynamic buffer, the best kind of buffer. The bigger the loss, the bigger the buffer," said Kalscheur.

"If the market is down 10% and you lose 5%, it's not as good as a typical 10% buffer.

"But if the index decline is 40%, this one would cause you to lose 20% while the buffer would generate a 30% loss.

"If it goes down to zero, you can't lose more than 50%. With the 10% buffer, you would lose 90%.

"I haven't seen a percentage buffer like that. I like that a lot. This is a very, very interesting product."

Carl Kunhardt, wealth adviser at Quest Capital Management, agreed.

"Typically, I don't use leverage. I think it's asking for trouble. But this is fairly novel. You're using leverage to enhance your upside while protecting your downside. It may not be a buffer, but it's acting like one," Kunhardt said.

"You already have less risk because your underlying index is going to dampen volatility. And on top of that, you know that your maximum downside is 50%. What's not to like about that?"

Low beta

The S&P 500 Low Volatility index is for investors seeking exposure to the stocks in the S&P 500 index with the lowest beta.

The volatilities of all S&P 500 constituents are calculated using daily standard deviation data for roughly the past 12 months, and the weight for each index constituent is set inversely proportional to its volatility (higher weightings are assigned to the least volatile stocks). The index is rebalanced quarterly.

The index has only been calculated since April 20, 2011, according to the prospectus.

A hypothetical table of annualized returns from Jan. 4, 2007 through April 19, 2011 comparing the S&P 500 Low Volatility index with the traditional benchmark was included in the prospectus. It showed that the S&P 500 Low Volatility index has outperformed the S&P 500 benchmark, although it warned investors that the hypothetical performance is not necessarily an indication of future results.

"This is a relatively new index. It's not uncorrelated to the general market and it tends to slightly outperform," said Kunhardt.

"It's a more boring type of underlying, but you tend to outperform in a flat to declining market. Obviously in a bullish momentum, you'll be left behind, but that goes with the territory.

"If you believe that the S&P 500 is going to be greater in five years, then you can certainly take advantage of the leverage and without a cap."

Kalscheur said that the product would be a great fit for some of his more conservative investors who tend to not have the stomach for the ups and downs of the market.

"Some clients want to be in the equity market, but they worry quickly and end up selling when stocks go down," he said.

"With this product, you can still participate and if the market is down, say it's down 20%, you're down only 10%. You don't have to sell at the worse possible time.

"Now, when the market is way, way up, that's going to lag, but it's designed to lag."

Forgoing dividends

A structurer said that he has seen the 150/50 upside/downside leverage features in other notes before but not that often.

"I've seen it with products tied to high-dividend stocks. The issuer would use the dividends to buy more upside and some level of downside protection," he said.

Kalscheur said that for investors, foregoing the dividends is indeed the price to pay for the attractive payout structure.

"This index pays about 3% in annual dividends. So after five years you're giving up 15%," he said.

"There's something to be said for giving up 3% a year if you're seeing the market remaining flat. But it looks like you can easily make up for it with the upside leverage.

"If the index is up only 10% in five years, that's 2% a year, you get 15%, and you break even. And 2% a year is really not that much. It's an index that doesn't even keep up with inflation."

Kalscheur said that both the upside and downside offer attractive features.

"You have leverage on the upside, without a cap, that's the beauty of it. And you get a dynamic buffer on the downside," he said.

"I really like this one. This is a very robust product. It would be a great complement for just about anybody who would have equity exposure."

Kalscheur said he also likes the credit rating of the issuer and the simplicity of the product, that it's easy to explain to clients, something he calls "passing the smell test."

"You just have to watch the fees," he said, noting that the prospectus indicated that fees could be up to 3.5%.

"If they do put a 3.5% fee and you spread it over five years, that's 70 basis points a year," he said.

Kalscheur said that he could buy the PowerShares S&P 500 Low Volatility Portfolio exchange-traded fund for a 25 basis points fee. The difference would represent almost half a point.

"I'm paying 45 basis points extra for the notes. But I'm getting a 50% cut on the losses and 150% participation on the upside," he said.

Two more

HSBC USA is also planning to price two notes linked to the same index but with a simpler payout. They offer 100% participation on the upside and 100% principal protection on the downside, according to two FWP filings with the Securities and Exchange Commission.

One product is a five-year note, and the other is a six-year note.

Kunhardt said that he would prefer the 50/150 performance notes rather than the more traditional fully protected products, which do not offer any upside leverage.

"The structure does not add much value compared to the notes that give you the 50/150 participation, and you commit your money for five or six years. I would much rather buy the ETF, put a stop on it and sell if I need to but keep the liquidity," he said.

"If the index was a volatile underlying like the Russell 2000 or the MSCI EEM, then I may go for the fully principal protected notes," said Kalscheur. "But this is already a conservative index. I would feel pretty comfortable with the 150/50 structure."

The 50/150 performance notes (Cusip: 4042K1XB4) will price Feb. 24 and settle Feb. 29.

The two principal-protected notes based on the same underlying index will price on the same day.

HSBC Securities (USA) Inc. is the underwriter for all three products.

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