HSBC's notes linked to Asian indexes offer some protection, leverage, but cap limits upside

By Emma Trincal

New York, Feb. 3 - HSBC USA Inc.'s plans to price return optimization notes tied to a basket of three Asian equity indexes via UBS may appeal to moderately bullish investors in China who seek some level of principal-protection and are willing to cap their returns for that, sources said.

HSBC plans to price 0% return optimization securities with contingent protection due Feb. 28, 2013 linked to a basket of indexes, according to an FWP filing with the Securities and Exchange Commission.

The basket includes the Hang Seng China Enterprises index with a 33.34% weight, the Hang Seng index with a 33.33% weight and the MSCI Singapore index with a 33.33% weight.

If the basket return is positive, the payout at maturity will be par of $10 plus 1.5 times the basket return, subject to a maximum return of 45% to 51% that will be set at pricing.

If the basket return is between zero and negative 40%, the payout will be par.

If the basket return is less than negative 40%, the payout will be par plus the basket return.

Go long China

"It's a way to go long Asian stocks without too much downside," said Greg Feirman, president and chief executive officer of Top Gun Financial Planning in Granite Bay, Calif. "The investor has to be moderately bullish on these markets."

In order to be attracted to the investment, investors must believe that the underlying basket will rise over the three-year period but not in excess of the cap, according to the prospectus.

"A bad outcome is if the basket gains more than the cap, then you lose a portion of the returns," Feirman said.

The three indexes with an equal 33.33% weight generated a return of about 52% for 2009 alone, which happens to be on the higher range of the maximum return offered in the deal.

Some protection

"But if you're skittish about the market, you get 40% of your downside protected. This is great if you're slightly bullish on the upside and concerned with the downside," Feirman said. "A bad outcome would be if the basket declines by more than 40%."

According to the prospectus, a basket decline of more than 40% submits investors to the risk of losing their entire principal because they can lose at that point 1% of par for every 1% that the basket declines from the initial value.

Real annual return

Philip Davis, hedge fund manager at Capital Ideas in Woodland, N.J., examined the cap feature of the deal and said, "You really have to look at the compounded return taking into account the 45% to 51% maximum return. What you're really getting is about 13% a year, and that's the most you can possibly get."

"You have to deconstruct the investment and figure out what your best-case scenario is," he added.

The basket needs to gain about 8.5% a year to generate the 13% return after applying the 1.5 times leverage, he noted.

"So really, 8.5% of your 13% comes from the market appreciation. The bank is only paying you approximately a 4.5% bonus, and that's the max that you can get," said Davis.

"The only way for you to get the bank to pay you the 4.5% extra is to get the market to gain 8.5%. But you're giving them the excess return for free."

Not risk-free

Looking at the downside, Davis said that the 40% protection is a plus but probably not enough to convince him to choose that type of investment over an option strategy or exchange-traded fund alternative.

"If you lock your money up for three years in the Chinese markets and pretend that there is not a risk to see a big market correction, I think you're fooling yourself," he said.

Hedging the risk

Davis said that the bank's rationale for offering the notes is easier to understand.

"If you're the bank, there is a way to hedge that. You can take a put option on the Asian indexes to offset the risk of a basket decline. The bank buys China stocks or already has a position, and they'll transfer the ownership to you. You get to pay them now. When they get the money, they can leverage it 10 times for loans. There's nothing wrong with that. That's what banks do," Davis said.

While Davis is skeptical about the value of the notes for investors, he said that in some cases, the structure may be helpful.

"Conceptually, it could work for someone who worries that the Asian equity market could drop but who doesn't foresee a huge correction. It could also make sense for someone who is comfortable having his gains capped to 13% a year," said Davis.

But the manager, who specializes in options, emphasized some of the risks, all of which are described in the prospectus.

"You still need to understand that you have no guarantee that you'll get anything. You could lose everything. You could get only par over three years, with no payout, and that's a risk. You could get 3% and not keep up with inflation, and that's a risk too," Davis said.

"I guess if you had to be invested in China and felt nervous about the downside, this may be a way to hedge your exposure," he said.

The notes are expected to price Feb. 23 and settle Feb. 26.

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

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