Dow industrials-linked deals show similar risk, different growth expectations, analyst says

By Emma Trincal

New York, Oct. 16 - Issuers have announced several notes offerings referencing the Dow Jones Industrial Average, a trend that breaks with the usual custom of linking notes to the S&P 500 index, said Suzi Hampson, structured products analyst at Future Value Consultants, who reviewed two such deals showing similar risk levels but different market growth expectations.

S&P versus Dow

"Definitely with U.S. structured products, it's always the S&P 500 not the Dow Jones," said Hampson.

"I'm not sure why besides the fact that the S&P 500 is a broader index representative of the whole U.S. equity market while the Dow Jones Industrial represents a more specific group of stocks. Or perhaps it's just because the S&P 500 has been the trend for so long and that people are comfortable with it."

One would think that the volatility of the Dow would be greater than that of the S&P 500, said Hampson. The Dow Jones Industrial comprises 30 stocks versus 500 for the S&P. But Hampson noted that it is not the case.

While the Dow industrials' annualized historical volatility at 39.91% is higher than that of the S&P 500, which is 32.98%, both indexes have a fairly similar implied volatility at the moment.

"However, it's hard to predict whether or not we're seeing the beginning of a new trend with the Dow Jones being used more often as an underlying looking forward," Hampson said.

"My take is that those two indexes are not interchangeable," she added.

Hampson compared two recently announced accelerated growth notes tied to the Dow.

Two Dow deals

The first one, a two-year product, was announced by Citigroup Funding Inc. The bank said it planned to price 0% buffer notes due 2011 linked to the Dow industrials, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus about 200% of any index gain, up to a maximum return of 26% to 30%. The exact participation rate and cap will be set at pricing.

Investors will receive par if the index declines by 10% or less and will lose 1% for every 1% that the index declines beyond 10%.

The second product was different in that it was a four-year note, had no cap and will employ very little or no leverage.

HSBC USA Inc. plans to price 0% uncapped market participation securities due Oct. 28, 2013 linked to the Dow, according to an FWP filing with the SEC. The payout at maturity will be par plus 100% to 110% of any index gain, with the exact participation rate to be set at pricing. Investors will receive par if the index declines by 10% or less and will be exposed to any decline beyond 10%.

Two different plays

Looking at the Citigroup notes, Hampson said: "A two-year is much more standard in the U.S. with 200% leverage on the upside up to a cap. This is a very standard product that should appeal to investors who think the market is going to rise perhaps moderately and want to capture double the growth."

Assuming that the cap would be set at 26% - the low end of its indicated range - an investor would earn the maximum capped return if the market was up by simply 13%, she said. On the other hand, if the market rally was more significant, investors would lose the opportunity to earn more than the 26%, she said.

Looking at the HSBC securities, Hampson commented: "This is quite different. It's a longer term. It's uncapped, which means that you are an investor who thinks that the Dow is going to grow by a considerable amount in the next four years."

Hampson said that the four-year maturity was particularly atypical. Unlike the United Kingdom, where issuers offer many five-, six- or even seven-year structured notes, longer maturities are not very common in the United States, she said.

The uncapped aspect of the HSBC structure suggests that investors in those notes are more bullish. "They don't want the cap on the return," she said.

"They're a different play," said Hampson comparing the two products. "With one, you make the sacrifice of having a cap for a double gear. With the other, you have uncapped returns but only a single gear."

Both products share some characteristics though, Hampson said. In both cases, the notes are growth products with no income payment. "In that way they appeal to similar investors," she said.

In addition both have a 10% buffer, which protects the principal if the index falls by less than that percentage during the term.

Same risk

Hampson said that the presence of a 10% buffer with this type of underlying is not very meaningful in terms of risk protection. "Both types of investors are willing to take on a lot of risk because a 10% buffer is not a huge protection element," she said.

The similarity in risk is reflected by very similar riskmaps, Future Value Consultants' rating that measures the risk associated with a product on a scale from zero to 10. The HSBC notes and the Citigroup securities have a 7.15 and 7.50 riskmap respectively.

"Our indicators show that the risk is quite similar. For both products, you have to be willing to take a high level of risk," said Hampson.

Future Value Consultants' opinion on the quality of a deal is expressed in its overall ratings. The consulting firm rated the HSBC deal 5.17 on a scale of zero to 10, notably less than the 7.50 rating assigned to the Citigroup notes.

Those ratings take into account costs, structure and risk-return profile.

Citi has more value

Hampson said that the gap in overall ratings between the two products in this case should be attributed to their different value ratings.

The value rating is the firm's measure of how much money the issuer has directly spent on buying the assets versus other transaction costs such as direct fees and profit margin. It is measured from zero to 10 and is one of the components of the overall rating.

The HSBC product has a 1.58 value rating. Citigroup scores 9.40. "There is a huge difference here. We think that the issuer of the four-year product is taking out significantly more fees and costs than the two-year issuer," she said.

The HSBC notes will price Oct. 23 and settle Oct. 28. HSBC Securities (USA) Inc. is the agent.

The Citigroup notes will price this month. The issuer has applied to list the notes on the NYSE Arca under the symbol "BGJ." Citigroup Global Markets Inc. will be the underwriter.

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