HSBC links barrier optimization securities to S&P 500 - protection at a cost, adviser says

By Kenneth Lim

Boston, April 22 - HSBC USA Inc.'s planned barrier optimization securities linked to the S&P 500 index gives cautious investors downside protection in exchange for giving up gains beyond a cap, an investment adviser said.

HSBC plans to price the notes due May 3, 2010 linked to the S&P 500 through agent UBS Financial Services.

At maturity, investors will receive 103% of their principal if the index closed above 131% to 135% of its initial level during the life of the notes. The exact barrier level will be set at pricing.

If that barrier has never been breached, investors will receive par plus any gain in the index at maturity. If the barrier has not been breached and the index ends between zero and 75% of its initial level, investors will receive par. Investors will lose 1% for every 1% decline in the index below 75% of its initial level, provided the upper barrier has not been breached.

Price of protection

Investors are giving up participation in any gain above the upper barrier in exchange for the buffer, the adviser said.

"Your downside is protected against a 25% drop in the S&P, that's the buffer, so your principal loss only starts from 75% and below," the adviser said. "That's basically what the investor is paying for. The price is the cap, basically the investor won't have any substantial return if the S&P grows above 31% to 35%."

The upper barrier can hurt and help investors, the adviser said.

"If the barrier is breached, you only get a 3% return, which is peanuts," the adviser said. "On the other hand, the product becomes kind of principal protected if that happens. If the S&P is very volatile, it goes up by 36%, for example, and within a year falls back down below its starting value, let's say it ends down by 10%, then you still get 103%. So it's not completely negative for the investor."

But the adviser said a barrier breach is more likely to hurt the investor.

"It's more likely if the S&P has gone up by 36% that it will be closer to that level at the end of a year than below the starting level, especially when you consider how far it's fallen since the start of this crisis," the adviser said. "It's almost certainly closer to a bottom at this level than two years ago."

Complex strategy

The product has an unusual strategy that is neither very cautious nor aggressive, the adviser said.

"There are some parts of it that look quite conservative, like the 25% buffer and the principal protection if the barrier is breached," the adviser said. "But it's not really a low-risk investment because ultimately you still have 75% of your principal at risk. But it's not really a very bullish product either, because if you're very optimistic about the S&P, you wouldn't like the fact that you only get 103% if the S&P goes up very high. And there's no leverage on the upside, it's just a participation rate of one. If you're optimistic about the S&P, you'll prefer more leverage."

Investors who find the product attractive probably see the underlying increasing moderately in the next year, the adviser said.

"The implied outlook is that the S&P will be between zero and 31% to 35%, whatever the cap is," the adviser said. "But again, if you have that kind of an outlook, I imagine you'd want to get some upside leverage rather than pay so much for a 25% buffer. Maybe it's because it's HSBC. They're one of the better credits in the market and maybe that's the kind of pricing they can get because of that strength."

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