HSBC's dual directional notes due 2013 linked to S&P 500 bring unease due to daily observation

By Emma Trincal

New York, April 5 - HSBC USA Inc.'s 0% dual directional knock-out notes due April 24, 2013 linked to the S&P 500 index should appeal to investors lacking a clear conviction about the direction of the market. However, the daily observation period for the knock-out event makes this product less appealing than other comparable notes, sources said.

A knock-out event occurs if the index closes below the initial level by more than 18% on any day during the life of the notes, according to an FWP filing with the Securities and Exchange Commission.

If the index finishes above the initial level, the payout at maturity will be par plus the gain, up to a maximum return of at least 15%. The exact cap will be set at pricing.

If the index finishes below the initial level and a knock-out event has not occurred, the payout will be par plus the absolute value of the index return.

If the index finishes below the initial level and a knock-out event has occurred, investors will be exposed in full to the decline.

Sideways

Dual directional products, or twin-win notes, are popular right now, said Steve Doucette, financial adviser at Proctor Financial.

The structure in general gives investors a positive return even if the underlying price declines as long as the decline does not exceed a certain threshold.

"These absolute value notes are awfully appealing if you believe that the market will trade range bound," he said.

But Doucette noted that the HSBC notes offer a different payout type than what he is used to seeing in the market.

"I like the ending value structure better because there is less likelihood to breach the barrier. With this, you can hit the trigger any time, any day. It's an American-style option. You can lose the protection and the benefit of the absolute value return much easier. If I had the choice between a European barrier where you look at the final performance only versus an American barrier like this one, I would choose the final barrier," he said.

Big deals

Two large dual directional deals with the point-to-point model recently priced. The term was two years instead of one year, but Doucette said that the payout structure was more attractive than that offered by the HSBC notes.

One was Morgan Stanley's $33.45 million of 0% dual directional trigger securities due March 31, 2014 linked to the common stock of Apple Inc.

If Apple shares finish above the initial price, the payout at maturity will be the stock gain up to a 50% cap.

If the stock finishes below the initial price but at or above the 75% trigger level, the payout will be par plus the absolute value of the stock return.

If the shares finish beyond the trigger level, investors will be fully exposed to the decline.

Another example was Citigroup Funding Inc.'s $29.75 million of 0% dual directional trigger Performance Leveraged Upside Securities due March 28, 2014 linked to the S&P 500. The upside leverage is 150%, the cap is 21% and the trigger value is 80% of the initial level.

The observation is done point to point. Between the trigger level and the initial level, any final decline translates into a gain. There is no knock-out event observable any day other than the final valuation date nor any chance to lose the protection and the absolute value payout prior to maturity.

"With all the volatility going on, all it really takes is one bad day to push it down and it blows the whole thing out," Doucette said.

"If you get knocked out, you're in the index and you get locked in for a year and capped at 15%."

The prospectus states the risk in clear terms: "The benefit provided by the knock-out buffer amount may terminate at any time during the term of the notes."

Challenge

Matt Medeiros, president and chief executive at the Institute for Wealth Management, said that while the one-year term appears more attractive than a longer maturity, "I'm not sure it makes such a big difference in a volatile market. What would make a difference would be a point-to point payout."

He added that "the challenge of a daily observation is when the market has a short-term setback," pointing to what happened in summer of last year, a time at which the market dropped sharply.

As an example, he mentioned the market direction between early July and early October. The S&P 500 during that period fell by nearly 20% and would have triggered a knock-out.

"If you look at the index every day, it's a little bit of a challenge," he said.

"You could easily breach the barrier if you have a market that goes through a whipsaw. You could easily get penalized.

"The summer of last year is still fresh in our mind, and it would be very difficult for me to swallow the structure.

"You'd have to ask yourself: Could this negative scenario happen again, and if it does, could it be more severe?"

HSBC Securities (USA) Inc. is the underwriter, and J.P. Morgan Securities LLC is the dealer.

The notes (Cusip: 4042K1D67) were expected to price April 5 and settle April 11.

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