HSBC USA's $40.25 million of 0% knock-out on gold, other deal seen as safer bets on gold

By Emma Trincal

New York, Oct. 13 - Investors continue to be bullish on gold but tend to favor structures that incorporate some level of protection, sources said, commenting on two knock-out buffer notes linked to the price of gold.

The first deal, sold via JPMorgan, already priced. It was HSBC USA Inc.'s $40.25 million of 0% knock-out buffer notes due Oct. 21, 2011 based on the price of gold.

The knock-out event occurs if the price of gold falls by more than the buffer amount of 20% during the life of the notes, according to a 424B2 with the Securities and Exchange Commission.

If a knock-out event occurs, the payout at maturity will be par plus the return on gold, with exposure to any losses.

If a knock-out event does not occur, investors will receive par plus any gain, with a contingent minimum return of 5%. The payout at maturity on this deal was capped at 17.5%.

Morgan Stanley too

Morgan Stanley announced a similar structure on the same underlying with its 0% Commodity Leading Stockmarket Return Securities due October 2012 linked to gold, according to a 424B2 filing with the SEC.

If the price of gold remains above 80% of the initial price throughout the life of the notes, the payout at maturity will be par plus the greater of the gold return and a fixed percentage of 12%.

If the price of gold falls to or below 80% of the initial level during the life of the notes, the payout will be par plus the gold return, which could be positive or negative.

In either case, the maximum payout at maturity will be capped at 30%.

A trader compared the two notes, pointing to the similarities.

"Both deals have a knock-out of 20%; they're both capped; and they both give you a fixed minimum return if there's no knock-out. The difference is the term - two years versus one; as well as the cap and the fixed percentage of minimum return," he said.

Safe bets for a bull

The trader said that he liked both deals because "both are actually safe bets."

Looking at the initial price of gold - $1,341.50, according to the prospectus as the deal priced on Friday - he said that "gold would have to go down to $1,072 for the knock-out to hit, and it's unlikely."

The three biggest drops in the price of gold in the past two years averaged 9.25%, he said.

"If the pullback averages less than 10%, this 20% put you have in those deals is twice the average. I don't see a knock-out being triggered, even with the two years," he said.

But he added that his view reflected his bullishness on the precious metal.

"I see higher gold prices ahead. I think things will stay as they are because the Fed can't afford to raise rates, Japan can't afford to raise rates, Europe can't afford to raise rates," he said.

Assuming that gold trades in a range, both deals offer benefits to investors, this trader noted.

"If it goes sideways, you still get 5% with the short term and 12% with the two-year. What do you have to buy to earn 5% these days?" he said.

"In both cases, the deals are almost kind of conservative. If you're a raging gold bull, you wouldn't do either of these. I think 20% is a fair amount of protection to generate a 12% on two years or even a 5% on one," he said.

If he had to choose between the two products, the trader said that he would opt for the two-year term with the 12% fixed-percentage contingent return.

"I think a 30% cap is more than generous. It's a lower cap than the cap offered by the other deal on an annual basis," he said.

"In addition, your fixed rate of return of 12% is greater than the 5%," he said.

At equivalent maturities and taking into account compounding, he said that the 5% rate for the one-year paper was the equivalent of a 10.5% return for two years.

"Gold keeps on going and going. How much more can it go? I don't know. Will it correct? I don't know. But it seems to me that both bets are actually safe bets," he said.

Playing defense

Commenting on the $40 million size of the HSBC deal, a sellsider said that, "People are getting more defensive on gold. They expect a correction. That's why this deal did well. You get exposure to gold but with some protection. Someone really bullish on gold wouldn't go for it. They wouldn't want the cap."

This sellsider added that investors' appetite for gold is likely to continue as people seek a hedge against inflation as well as a hedge against currency depreciation. But he added that he was not in favor of notes that do not offer a fixed coupon.

"People like those contingent returns. I tend to prefer a fixed coupon. If you have to be paid a coupon, you might as well have it guaranteed," he said.

J.P. Morgan Securities LLC is the agent for the HSBC deal.

The fees were 1%.

The Morgan Stanley notes (Cusip: 617482NZ3) will price and settle in October.

Morgan Stanley & Co. Inc. is the underwriter.

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