HSBC's tracker notes linked to Euro Stoxx 50 offer some protection and leverage without cap

By Emma Trincal

New York, April 22 - HSBC USA Inc.'s 0% contingent protection leveraged tracker notes due October 2017 linked to the Euro Stoxx 50 index exemplify a recent trend of uncapped, leveraged deals that offer a competitive barrier protection without penalizing investors on the upside, sources said.

If the index return is greater than zero, the payout at maturity will be par plus at least 165% of the index return. The exact upside participation rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the return is less than or equal to zero but greater than or equal to the barrier level, negative 25%, the payout will be par.

If the return is less than negative 25%, investors will be fully exposed to the decline from the initial level.

Attractive terms

"The leverage and the no cap: that's outstanding. These terms are really attractive. I still tend to prefer products that pay an annual coupon, but if you want participation in this index, this is an extremely attractive note for these euro bulls," said Dean Zayed, chief executive officer of Brookstone Capital Management.

This product illustrates a recent trend of notes with no maximum return, he noted.

"I see fewer cap deals in general. But you usually have to give up something; it could be less leverage, for instance," he said.

Some structures offer shorter durations, such as one year or 18 months, but the leverage factor would be considerably less than 1.65, he said. Most of those uncapped, shorter-dated notes feature low leverage - 1.1 times, for instance - or even a one-to-one upside participation, according to data compiled by Prospect News.

"When you combine the 1.65 times leverage, the no cap, the fact that it's only three and a half years with a 25% protection still, these are three or four attributes that you don't often see together in a product. This structure is extremely solid," Zayed said.

No big yield

For Jonathan Tiemann, founder of Tiemann Investment Advisors, LLC, what investors have to give up in this note is the high yield paid by the Euro Stoxx 50, a benchmark composed of 50 large-cap stocks from the euro zone.

"Investors have to forego the 2.75% dividend yield. But the issuer needs this to structure this product. If the yield was zero, this would be an impossible product. Think about it. Apart from dividends, this structure gives you a better payoff in almost every scenario compared to a direct investment in the index fund," he said.

"You're no worse off if the index is down by more than 25%. You're better off if it's not. And you're better off if it's positive. You've sacrificed the dividends, but you're getting a lot in return.

"Of course, you have the usual caveat associated with all structured notes: credit risk of HSBC, lack of liquidity. But that's true for all products."

Payoff convexity

Tiemann said that the "convexity" of the product's payoff is by definition what makes it valuable compared to the underlying itself.

"What you're doing is sacrificing the dividends in exchange for more convexity in your payoff," he said.

"If you look at the index fund on a graph, including price and dividend, you get the payout plotted on a straight line.

"With this product, the diagram gives you from minus 25 to zero a flat line and above zero, a line with a steeper angle than the market. That figure represents a convex payoff.

"You're trading income for volatility. You're using the dividends to buy volatility.

"You want convexity because you think volatility is going to increase.

"You're buying the leverage at a lower cost as you anticipate volatility to move higher. And you use the dividends to buy the calls used for the leverage. It gives you some good leverage."

Anti cap

Tiemann also noted that issuers are striving to do without caps on leveraged return products.

"You can see why people would want to get rid of the caps. The leverage may be attractive, but it may not be worth anything if the cap is too low," he said.

But raising or eliminating caps involves concessions on the part of investors.

"Obviously, to get rid of the cap, you have to give something back. In this case, you're giving back the term; I mean you're increasing the time during which you'll be locked in. This is not a one- or two-year note. In addition, you're giving up a fair amount of dividends. These are the two main ways to do that.

"It's not a bad structure. They did a nice job at getting rid of the cap.

"You always have a trade-off. Extending the length of the deal is one possibility, but not all investors are comfortable with that. Foregoing dividends in exchange for a more convex structure is another way. In this product, they did both."

Downside

The notes give access to the European large-cap stock market with full upside potential and enhanced return via the leverage. In addition, investors benefit from 25% worth of contingent protection.

"Europe can be risky, but so are many other equity markets," Tiemann said.

"The 25% protection does not sound like a bad number, although one would have to price it. But it's hard to imagine how the issuer could create the same structure with more downside protection," he said.

Contrarian

For Zayed, the unlimited upside with contingent protection along with the simplicity of the structure could give the product a lot of traction.

"The terms are so simple, you know what you're getting into. It's easy to sell this note to most investors who are looking for somewhat of a contrarian view," he said.

"European stocks have been lagging the U.S., and a lot of investors see attractive valuations in this market. It's a play on Europe bouncing back.

In 2013, the S&P 500 gained 32% while the euro zone benchmark was up 24.5%.

So far this year, however, the Euro Stoxx 50 with a 2.75% return has outperformed the U.S. market by one point.

"To some extent, we're already seeing European economies recovering. The tail risk we had in 2011, 2012 when some European countries were on the brink of collapse is dissipating. Europe is not completely out of the woods yet, but things look like they are more stabilized. Even Spain looks more stable. Plenty of people are bullish on Europe, and for them, this is a very attractive note," he said.

HSBC Securities (USA) Inc. is the underwriter.

The notes will price and settle in April.

The Cusip number is 40432XYR6.

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