HSBC's $83.87 million 13.15% notes on General Electric tap into high volatility, big name

By Emma Trincal

New York, May 26 - HSBC USA Inc.'s large sale of reverse convertible notes tied to the share price of General Electric Co. was popular partly due to the blue-chip name and the stock's high implied volatility, attributes that enabled the issuer to offer an above-average yield, sources said.

HSBC priced $83.87 million of 13.15% yield optimization notes with contingent protection due May 31, 2011 linked to the common stock of General Electric, according to a 424B2 filing with the Securities and Exchange Commission.

Each note priced at par of $16.42, which was the closing price of General Electric stock at pricing.

Interest is payable monthly.

If General Electric stock finishes at or above 75% of the initial price, the payout at maturity will be par. Otherwise, investors will receive one General Electric share per note.

Big, retail

"It was a very large deal," said a source familiar with the product. "It worked because people like the name and the terms."

"It was definitely retail," this source added.

Rising volatility

Michael Iver, former structurer at JPMorgan, said that General Electric, as the underlying stock, offered several benefits that all contributed to the high payout.

Iver first compared the growth of the implied volatility of the stock over the past 30 days - from April 21 to May 21 - with that of the S&P 500 index, as measured by the SPDR S&P 500 exchange-traded fund.

During the period, the overall market implied volatility grew from 21% to 32%. By comparison, General Electric's implied volatility went from 31% to 47%.

"In both cases, implied volatility surged by a little bit more than 50%. Such rise is good for investors who sell volatility in those structures," Iver said.

Conglomerate name

Secondly, General Electric is also attractive for investors seeking diversification given the diversified nature of is production, including technology, media and financial services, Iver noted.

"What's interesting with General Electric is that the name, as a large-cap, diversified conglomerate, allows investors to get exposure to a broader market. Yet they get a higher nominal implied volatility than the overall market, and that allows them to receive a high coupon," said Iver.

"That's why you see more and more reverse convertibles structured around a single name," he added.

High coupon

As with any reverse convertible, the issuer will pay investors the 13.15% coupon regardless of the performance of the stock.

The coupon, according to the prospectus, is designed to compensate investors for the loss of some or all of their principal.

In addition, investors will get their principal back, subject to the creditworthiness of HSBC, as long as the stock does not close below the 75% trigger price, according to the prospectus.

Shares of General Electric closed at $16 Wednesday, up 5.82% for the year.

The stock is 23% higher than a year ago.

The deal may be most attractive to investors who are betting that the stock will "trend sideways" over the next year, "moving neither positively, by more than the coupon paid on the notes, nor negatively, by more than the amount of contingent protection," according to the prospectus.

"A 13% is pretty high," said Iver. "If you compare it to the high-yield index, which gives you about 7% over Libor, you're getting an equity return in a yield-enhanced note."

Sometimes notes offering higher-than-average coupons tend to have less protection.

But Iver said that the 25% protection "is a standard knock-in level."

"It's a huge deal, and it has to do with the way the issuer can hedge the trade with confidence," said Iver.

Hedge efficiency

"A large-cap diversified name like GE can support a deal of this size without moving the market," he said.

Iver explained that in a reverse convertible structure, investors sell a knock-in put option to the dealer. In turn, the dealer has to hedge the put option that he buys from the investor. He simply does so by selling a listed put to the market.

"With a very liquid and big name like this, the bank can manage its hedging activity without moving the market against the investor," Iver said.

The opposite example would be hedging a put option on a small-cap stock.

"With a small cap name, the dealer when selling the put may cause the price of the implied volatility to drop," he said.

Since implied volatility is the price of the option, the dealer would face fewer buyers in a thinly traded, more illiquid market. With fewer bids, volatility would "collapse," Iver explained, which would adversely impact the investor because the cost of hedging is factored into the coupon.

"The dealer has to anticipate the impact of its hedge, and it would be reflected on the coupon it offers the investor," said Iver.

"With a large-cap name like GE, the dealer can hedge that exposure more confidently knowing that there is a lot of liquidity for the options and a lot of players. As a result, the ongoing cost of hedging is less expensive for the issuer. And all that can be passed on to the investor in a higher coupon."

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

Fees are 1.75%.

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