HSBC, Morgan Stanley offer bearish equity-linked notes; cautious investors eyed: adviser

By Kenneth Lim

Boston, Aug. 24 - Bearish products linked to the equity markets are getting a closer look from cautious investors who are looking to hedge against the asset class' recent rally, an investment adviser said.

HSBC USA Inc. recently priced $5.02 million of zero-coupon bearish return optimization securities due May 26, 2010 linked to the Russell 2000 index.

The payout at maturity will be par of $10 plus triple the absolute value of any index decline, subject to a maximum total payout of 119.5% of the principal. Investors will receive par minus the index return if the index advances.

UBS Financial Services Inc. and HSBC USA Inc. were the underwriters.

Morgan Stanley is also offering zero-coupon Bear Market Performance Leveraged Upside Securities due Oct. 28, 2010 linked to the iShares MSCI EAFE index fund.

The payout at maturity will be par of $10 plus double the absolute value of any index decline, subject to a maximum total payout of 119.5% to 121.5% of the principal. Investors will lose 1% for every 1% increase in the index.

Rally concerns

The market is not completely convinced about the recent rally in the equity markets, the investment adviser said.

"There are still a lot of mixed signals out there, so there's still no consensus on whether we're firmly on the way to a recovery," the adviser said. "There are still concerns about the property market, consumer spending, employment."

That lack of clarity makes it a "ripe" time for bearish products, the adviser said.

"If there's anything that investors have become since the second half of 2008, it's very, very cautious," the adviser said.

Potential hedges

Bearish products allow investors to earn a positive return on their investments even when the underlying markets are not doing well, the adviser said.

"You're investing in the market with both of your hands, as compared to having a long-only portfolio, which can be a bit like playing with one hand tied behind your back," the adviser said.

Investors can also use the products to hedge against existing long positions if they feel that they need additional protection on the downside, the adviser said.

"Most of the bearish products are leveraged, so that allows you to potentially create market-neutral effects within certain performance bands of the underlying assets," the adviser said.

But the adviser noted that bearish products tend to be highly risky on their own.

"Most of the time you have very little or no protection if the underlying index does well," the adviser said. "Your maximum payout on these products is usually much less than the amount you stand to lose."

The lack of good secondary pricing could also affect the ability of investors to close their positions early, the adviser said.

"If the underlying index is up by 15% and I want to stop my losses, or if the index is down by 15% and I want to take profit, the price that I can get for selling these notes isn't going to be the same as if I'm closing an actual position in the index," the adviser said. "There's an option here that affects the price and there's no liquid secondary market to set a price."

But investors probably have little choice if they want the leverage, the adviser said.

"That's the price you have to pay if you want 300% or 200% leverage," the adviser said.

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