HSBC prices two deals for $86.5 million and $30.8 million linked to bank-specific KBW index

By Emma Trincal

New York, July 30 – JPMorgan brought to market last week two large deals linked to a banking sector index, a sign according to sources that investors are increasingly pursuing “niche” strategies or at least more targeted bets than those offered by the broader benchmarks or even the common sector exchange-traded funds.

Both deals, which priced Friday, had the same maturity date and were brought to market by the same issuer.

HSBC USA Inc. priced $86.5 million of 0% notes due Jan. 30, 2015 linked to the KBW Bank index, according to a 424B2 filing with the Securities and Exchange Commission. The notes (Cusip: 40433BHR2) carried a 0.3% fee.

In addition, HSBC priced $30.8 million of 0% notes due Jan. 30, 2015 linked to the KBW Bank index, according to another 424B2 filing. The notes (Cusip: 40433BJT6) carried no fee.

A small amount of leverage was applied to the upside in both structures. The participation rate in the larger offering was 100.39% while it was 100.70% in the second one.

The KBW Bank index is a float-adjusted modified-market capitalization-weighted index that seeks to reflect the performance of publicly traded companies in the United States that do business as banks or thrifts. Keefe, Bruyette & Woods, Inc. is the sponsor.

As of Feb. 26, the top three components of the index were Bank of America Corp. with an 8.70% weight, JPMorgan Chase & Co. with an 8.23% weight and Citigroup Inc. with an 8.17% weight, according to the prospectus.

Sources said the deals were designed for investors seeking access to the banking sub-sector of the financial industry as described by the index, which excludes other financial businesses such as mortgages or insurance.

Banks and nothing else

The sources noted that investors chose not to use two well-known ETFs covering the U.S. financial services industry that are commonly priced into products.

One of those two funds is the Select Sector Financial SPDR ETF listed on the NYSE Arca under the “XLF” ticker symbol and based on the returns of the S&P Financial Select Sector index. The other is the iShares Dow Jones U.S. Financials ETF listed under the “IYF” ticker.

“But those funds don’t focus on banks only,” said a bank analyst at a research firm.

“They give a broad exposure to the U.S. financial sector that’s not limited to banks.”

Banks and thrifts make for only 37% of the XLF fund. The rest is comprised of insurance stocks, REITs, capital markets, consumer finance and real estate companies.

Some of the largest holdings in the IYF fund are non-bank entities such as Berkshire Hathaway Inc. and American International Group, Inc.

Modified capitalization

Another factor for the choice of the KBW underlying could have been the market capitalization methodology employed by Keefe, Bruyette & Woods.

“Keefe, Bruyette & Woods have been around forever. Their whole business is in the financial sector,” said Jim Delaney, head trader at Market Strategies Management.

“It’s float-adjusted, meaning they look at what’s out there trading in the market as opposed to market cap that takes into account all the outstanding shares. The free float gives a better picture of the performance. It’s not that diluted.

“It’s a weighting by the amount of stocks in the market, stocks that people can actually move by buying and selling.”

In a float-adjusted market capitalization index, only the free-floating shares are taken into consideration.

“In a modified market cap index, the largest holdings are usually capped at 10% of the index,” the bank analyst said.

This rule applies to the KBW Bank index, according to the prospectus, which indicates that no security can have a weight in excess of 10% in the index.

“Modified capitalization weighted indexes are not uncommon. It’s a way to prevent very big holdings to dominate,” he added.

“Float-adjusted is another issue. You can do the market capitalization in one or two ways. You can use the total value of shares available for purchase by the open market, and that’s the free-float methodology. Or you can use all the outstanding shares, which are all the shares issued by the company, and that includes shares owned by insiders that are not available to investors.”

The Dow Jones U.S. Financials index is float-adjusted. On the other hand, the S&P Financial Select Sector index is not, according to the fund’s prospectus, indicating that the market capitalization methodology is applied in order to ensure that each component stock is represented in proportion with its weight in the total market.

“There could be a number of reasons to use this particular index,” the analyst said.

“There’s an ETF though that tracks this KBW,” he noted, pointing to the PowerShares KBW Bank Portfolio ETF, which is listed under the ticker symbol “KBWB.”

Customization

Whether the goal of the investor is to change the weightings of some of the existing financial indexes; narrow the focus to bank stocks only or use a note as a substitute for an ETF for regulatory or tax reasons, investors ultimately benefit from more flexibility than before when they use structured notes to target a specific requirement, a market participant said.

“We’re seeing more and more specific indexes, customized baskets. This is a trend that’s catching on,” he said.

“You still have of course the big equity benchmarks, the S&P, the Russell or the Euro Stoxx. But sometimes investors do not want such a broad exposure. We’re seeing increasing appetite for sector-specific bets via sector or strategy indexes or funds.

“Just last week, for instance, we saw a couple of big deals on oil and on housing.

“Here, we probably have an investor who likes the banking industry but who wants to readjust the weighting. Maybe they don’t like other indexes because they think there’s too much concentration in some holdings. Therefore they look for another index. That’s when a modified market capitalization index comes into play.

“We’re also dealing with an investor or several investors who want to reduce their exposure to banks. Their demand is very specific.

“This is one of the benefits of structured products. You can get the risk-adjusted return that you want, you can choose the terms or you can pick the asset class of your choosing, but you can also reshape the index or the fund that you want exposure to and add your own criteria.

“The market is moving toward more and more customized products. It’s not one size fits all anymore.”

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