Copycat notes linked to Energy Select Sector index: watch credit risk, analyst warns

By Emma Trincal

New York, Oct. 23 - When structured products deals overlap in terms and maturity, investors should take into account the credit risk and cost of funding of the issuer, said Suzi Hampson, structured products analyst at Future Value Consultants.

She said that most of the time, issuers introduce differentiating terms only on pricing day, especially when deals price simultaneously, but that in the meantime, analysis before pricing is rendered difficult because many structures mimic one another.

In particular, she said, it's more challenging for analysts to differentiate deals prior to pricing when issuers give vague indicative terms, such as for instance a wide range of possible return caps, she said.

She compared two very similar accelerated growth deals with a two-year maturity and the same underlying fund - the Energy Select Sector SPDR fund. In both deals, investors are fully exposed to any fund decline.

Both transactions are set to price this month.

Citi and HSBC

The first deal is from HSBC USA Inc., which planned to price two-year 0% accelerated market participation securities linked to the Energy Select Sector SPDR fund, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 500% of any fund gain, subject to a capped return that is expected to be 35% to 45% and will be set at pricing.

The second deal was announced by Citigroup Funding Inc.

"It's exactly the same structure," said Hampson, pointing to the 0% two-year Stock Market Upturn Notes linked to the Energy Select Sector SPDR fund.

Citigroup's maximum return is expected to be 36% to 41%, according to an FWP filing with the SEC.

The payout at maturity for this Citigroup product will be par of $10 plus five times any fund gain, subject to the maximum return. "You have the same term, the same 500% participation rate and the same underlying," said Hampson. "These are structures that obviously overlap and I would expect some changes if they price on the same day," she said.

Credit risk watch

Pursuing her comparison between the two products, Hampson identified two differentiating factors: the credit risk of the issuer and the cap range. She said that investors should take those distinct points into account.

She noted that Citigroup has a lower Standard & Poor's rating than HSBC, with Citigroup rated A and HSBC rated AA.

"In addition, credit default swaps spreads are wider for Citi, which indicates that their cost of funding is greater than for HSBC," Hampson said.

"We would have to wait and see if both price on the same day. But if they do, an issuer - in this case Citi -with a higher funding level should be able to give you better terms because it indicates higher risk. If they priced on the same day and offered the same terms, you as an investor would be better off with HSBC," she said.

Two-year credit

Looking at the identical two-year maturities, which Hampson viewed as "a rather long term," she said that investors should be even more cautious about credit risk. "The longer the maturity, the greater the effect of the credit because there is a higher probability to have some kind of credit event," she said.

Since both deals offer the same tenors, the same participation rates and the same underlying, Hampson said that "You would expect Citi to raise the cap."

So far, though, Citi has not done that. On Tuesday, the bank said in an FWP filing that it had lowered the cap to a 36% to 41% range - the level on which Hampson conducted her last report and made her comment - from an original range of 45% to 47.5%.

Twin ratings

Future Value Consultants provide ratings that focus on structure analysis. Given the similarities between the two deals, Hampson said that both transactions received very similar scores.

The overall rating for HSBC was 7.65 and for Citigroup was 7.59.

This rating, on a scale of zero to 10, is the firm's opinion on the quality of a deal, taking into account costs, structure and risk-return profile.

"Our overall rating really takes into account the structure. Credit risk is not the relevant factor," Hampson said.

For the same reason, the riskmaps are very close, she added, with HSBC scoring 7.68 and Citigroup 7.71.

The riskmap, another Future Value Consultants' rating, measures the risk associated with a product on a scale from zero to 10.

"Here again, the ratings are very similar because our analysis is associated with the product's structure. There is an element of credit for this rating though, that explains the fact that Citi's risk is a little bit higher," said Hampson.

"These two products are for investors who want to get exposure to this fund and are ready to lose some of their investment. They are betting that the underlying will go up in price but not too much, otherwise given the cap they would be better off investing directly in the fund. A 500% participation rate is quite generous. For each point of fund gain, you earn five times more. The higher the gear, the less you need the underlying to grow," she said.

Value glitch

Hampson noted that the two value ratings were "quite similar," adding that this "came as a surprise."

The value rating on a scale of zero to 10 is Future Value Consultants' measure of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

The value rating for HSBC and Citigroup was respectively 9.99 and 9.97. "Given that Citigroup's cost of funding is greater, this should not be the case," she said.

She offered several possible explanations. One of them is the difference in cap ranges, she said.

For Citigroup with a cap ranging from 136% to 141%, the range is 5%. In the case of HSBC, which shows a 135% to 145% cap, the range is 10%.

"Citi has a 5% range and it's reasonable. But the 10% range of HSBC is a little bit ridiculous," Hampson said.

"When determining the value rating, we take the average of the cap range. The wider range with HSBC notes makes it a little bit more difficult for us to price the actual value."

Hampson said that another explanation for the anomaly could be that the underlying is "fairly volatile" and that "prices could have very well changed in one day." We can only use one number for the cap and can only price for one day," she said.

"When the cap is set, we will be much more confident," she said, adding that her firm "rescores" the structures and updates the report.

Copycat deals

Hampson looked at another transaction also set to price this month with the same underlying.

"Those deals linked to the Energy Select Sector SPDR fund were very popular a year ago and it looks like they are reemerging in the market," said Hampson. "It's a bit of a coincidence that we're seeing three of them at the same time. But issuers tend to copy each other."

The deal has the same structure as the two others, she said, aside from a shorter maturity of 1.17 years.

Eksportfinans ASA plans to price 14-month 0% Accelerated Return Notes linked to the Energy Select Sector index, according to an FWP filing with the SEC. The payout at maturity will be par of $10 plus triple any gain in the index, with the return capped at between 22% and 26%. The exact cap will be set at pricing. As with the other deals, investors in this product are exposed to losses.

"Despite the shorter term, this is exactly the same structure," said Hampson. The overall rating for this structure is 7.32. Its riskmap is 7.64. The value rating is 9.69.

"This is simply for an investor pursuing the same goal but not willing to lock in his money for two years," she noted.

Looking at the 300% acceleration rate associated with the 22% to 26% cap, she said that," You need more growth to get to the cap. But if they had given investors a 500% participation rate, they would have had to reduce the cap."

HSBC Securities (USA) Inc. is the agent for this product.

Citigroup Global Markets Inc. is the underwriter for the Citigroup notes.

Eksportfinans plans to sell its notes via Merrill Lynch, Pierce, Fenner & Smith Inc., First Republic Securities Co., LLC and Banc of America Investment Services, Inc.

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