HSBC's floored CDs tied to 10 stocks marketed as alternative to more common index-based deals

By Emma Trincal

New York. Sept. 3 - HSBC Bank USA, NA's planned offering of floored annual income opportunity certificates of deposit linked to a basket of stocks is part of a trend that is picking momentum, according to market participants.

Rather than being tied to an index or a single name, the CDs are based on a basket of 10 common stocks, according to a term sheet. The deal matures on Sept. 25, 2015.

"The ability for issuers to offer a coupon generated as a result of the performance of 10 stocks rather than an index is somewhat of a new trend," said David Seibert, vice-president structured products at Advisors Asset Management Inc., the distributor. "This type of structure picked up a lot of speed and it is very popular among broker-dealers and investors."

The underlying basket given its small size is more volatile than a stock index, said Seibert. As a result the underlying gives more upside potential and more flexibility to the structure, he said. "It's easier to generate income out of a basket," he said.

The equally weighted basket includes the stocks of Abbott Laboratories, Apple Inc., Boeing Co., Chevron Corp., Goldman Sachs Group, Inc., Monsanto Co., Nucor Corp., Qualcomm Inc., PepsiCo, Inc. and Target Corp.

The CDs will pay a coupon in September of each year equal to the average of the returns for the basket stocks, subject to a floor of zero. Each basket stock's return will be capped at 9% to 12% and be subject to a floor of negative 30%, capping the loss of each individual stock, with the exact cap to be set at pricing.

If the average return of the 10 stocks is negative, the investor will not earn any coupon on that year.

But HSBC introduced the negative 30% floor per reference stock to give investors added comfort if one of the constituent companies in the basket was to go bankrupt. In such event, the negative 30% floor would limit the impact of any losing stock on the overall performance of the basket, Seibert said.

Longer maturity generates income

The term of the product - a six-year CD - along with the more volatile underlying, represents one of means used by the underwriter to generate enough gains to be able to offer investors an annual coupon.

"I don't think you could duplicate that structure with a shorter maturity because interest rates are simply too low," said Seibert. "Using a longer maturity really helps with the zero. It gives the issuer more money to spend."

Wright said that while the S&P 500 index has made significant gains since March, volatility and uncertainty are back. "People have been in a lot of pain last year after the fall of Lehman Brothers and at the same time, we've had a very strong rally. Being able to lock in double-digit returns while protecting your capital is a powerful punch in this uncertain market," said Seibert.

Leaving money on the table

For others, the idea behind such products is to convince investors to cap their gains, and in some cases, it may just mean leaving money on the table.

That's the view of Tony Romero, principal at Suncoast Capital Group, a deposit brokerage firm in Coral Gables, Fla., who said that he is skeptical about equity-indexed CD products in general and with this particular issue as he finds the cap to be "too low."

Commenting on the HSBC CDs, Romero said: "The underwriter has selected stocks which it feels will have the greatest potential for appreciation while at the same time capping the investors' potential gains at 9-12%.

"Over the next six years though, it's very likely that this basket of stocks will significantly outperform the 9-12% cap imposed on the investors which of course is great for the underwriter since they benefit from this greatly, and bad for the investors since they do not fully participate in the appreciation of the stocks."

The CDs will be putable on Sept. 30, 2010, Sept. 30, 2011, Sept. 28, 2012, Sept. 30, 2013 and Sept. 29, 2014. Investors will receive the then-current market value of the CDs minus an early redemption charge of 3.5% in the first year, 2.5% in the second year, 1.5% in the third year and 0.5% in the fourth year. There is no charge in years five and six.

"This security could possibly make sense if the cap was significantly raised and the charge for 'putting' the CD was removed," said Romero. Or if perhaps a floor were installed that offered at least a minimal return of say 2% or so."

The 'need to be different'

The recent vogue of structuring CDs linked to a small basket of stocks is dictated by excess supply of too much of the same, said a financial adviser. "Issuers need to be different. The same index structures have been saturating the market. So they're offering a basket of stocks rather than an index," said this adviser.

The need to bring noticeable products reflects the success of offering principal protection through the use of CDs, this adviser said. Investors get more yield than what they would earn on U.S. Treasuries, the adviser said, adding that it allows them to take some profits from stocks after "a nice run" while giving them their money back at maturity.

The payout on the upcoming HSBC CDs at maturity will be par.

The certificates are expected to price Sept. 22 and settle Sept. 25.

HSBC Securities (USA) Inc. is the agent, and Advisors Asset Management, Inc. is the distributor.

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