HSBC's buffered notes tied to iShares U.S. real estate ETF offer value for specific sector

By Emma Trincal

New York, Dec. 3 - HSBC USA Inc.'s upcoming 0% buffered Accelerated Market Participation Securities due March 27, 2012 linked to the iShares Dow Jones U.S. Real Estate index fund offer value to investors seeking exposure to real estate returns with a limitation on risk, said structured products analyst Suzi Hampson at Future Value Consultants.

She explained that the value for this deal was related to the degree of liquidity of the underlying exchange-traded fund.

Mainstream underlying

"The iShares real estate index fund is not the most unusual underlying. In fact, it has become mainstream over the past year. It seems to be the fund people tend to be using when they seek exposure to real estate," said Hampson.

"In general, I'd say that the iShares have become very common ways for issuers to give investors [exposure] to a particular sector.

"You could create a note out of real estate prices or a note out of a basket of stocks in the real estate sector. But using an ETF makes it easier."

Liquidity advantage

The more liquid the underlying is, she explained, the cheaper the cost of the options used by the issuer to hedge.

"Hopefully this gets to be passed on to the investor, who should get better terms," she said.

In this deal, the two advantages of investing in the notes versus a direct investment in the ETF are the 10% buffer and the leverage factor of two, she said.

The payout at maturity will be par plus double any increase in the ETF's share price, subject to a maximum return of 15% to 20% that will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

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

"When your underlying is not very liquid, it will cost the issuer more to hedge, and as a result, investors will get hit with higher fees. Think of a very bespoke basket of commodities for instance. It will be expensive," Hampson said.

"With this product, the 9.12 value rating indicates that investors get some value. It's partly due to the liquidity of the underlying fund that gives the issuer more leeway."

Based on a scale of zero to 10, the value score represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis.

Risk-reducing factors

The risk associated with the product, as measured by Future Value Consultants' riskmap on a scale from zero to 10, is "decent" with a 4.16 score, said Hampson.

"It compares quite well with other products," she said.

Part of the limited risk derives from the implied volatility of the ETF.

The 25% implied volatility of the ETF is higher than 22.5% for the S&P 500, "but it's not that much higher, so this limits the risk as well," she said.

The relatively low riskmap is the result of several factors: the buffer, a short-term maturity and an implied volatility for the underlying fund that is not excessively high.

"If you had more volatility, a smaller buffer or a longer term, your risk would obviously be greater," she said.

Good return score

The return rating, Future Value Consultants' indicator on a scale of zero to 10 of the risk-adjusted return of the notes, is 5.84.

"This is a return score that's quite good. Our average is around 3.4," said Hampson.

"It's due in part to the high likelihood of hitting the cap."

The 15% to 20% cap on an annualized basis with compounding would be 11.83% to 15.70%, according to the report.

With the two-times leverage factor, investors need the iShares fund to only grow between 5.91% and 7.85% in order to hit the cap.

"You don't need to be extremely bullish when you buy those notes. A very bullish investor obviously would not tolerate the cap and would go for the fund directly," she said.

"The benefit of the notes over the equity comes down to the gearing and the buffer."

Because the underlying fund "does not require very much growth" for maximum return on the investment, the probability of hitting the cap is high, Hampson noted, pointing to the return probability tables.

Those show that investors have a 50.5% chance of hitting the highest gains bucket of 10% to 15%.

Overall, the likelihood of generating a positive return is 68.6% versus a 31.4% probability of incurring losses.

"The leverage increases the odds of hitting the cap, which is why the return score is above average," Hampson said.

The overall rating, which is Future Value Consultants' opinion on the quality of a deal, is 7.68 on a zero to 10 scale. Hampson noted that this score is also above average.

The notes (Cusip 4042K1AZ6) will price Dec. 22 and settle Dec. 28.

HSBC Securities (USA) Inc. is the agent.

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