Choice of high leverage versus high cap depends on how bullish investors are, analyst says

By Emma Trincal

New York, Feb. 12 - Leveraged notes often come with a limited return and investors need to decide whether they want a higher cap with less leverage or the reverse, said Suzi Hampson, structured products analyst at Future Value Consultants, adding that this choice is a result of each investor's market growth expectation.

To make her point, Hampson compared two upcoming notes with the same underlying exchange-traded fund, the iShares Dow Jones U.S. Real Estate index fund; the same 18-month tenor; and the same 10% buffer.

The only important differences were the respective levels of cap and leverage. Additionally, credit risk was another differentiating factor albeit a less significant one, Hampson noted.

The two distinct issuers are HSBC USA Inc. and Barclays Bank plc.

HSBC plans to price 0% Buffered Accelerated Market Participation Securities due Aug. 24, 2011 linked to the iShares Dow Jones U.S. Real Estate index fund, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus double any fund gain, subject to a maximum return that is expected to be 21% to 26% and will be set at pricing. Investors will receive par if the fund declines by 10% or less and will lose 1% for every 1% fund decline beyond 10%.

Barclays plans to price 0% Buffered Super Track Notes due Aug. 26, 2011 linked to the iShares Dow Jones U.S. Real Estate index fund, according to an FWP filing with the SEC.

The payout at maturity will be par plus three times any fund gain, up to a maximum return of 17.6% to 21.5%. The exact cap will be set at pricing.

Investors will receive par if the fund shares fall by up to 10% and will lose 1% for each 1% drop beyond 10%.

Similar downside risk

Hampson began her comparison looking at riskmap, Future Value Consultants' rating that measures the risk associated with a product on a scale of zero to 10.

Riskmap was 7.51 for the HSBC notes and 7.49 for the Barclays product.

"Riskmap looks at the downside, or the chance of a capital loss," said Hampson. "Since both structures have the same 10% buffer, the same tenor and the same underlying, they should have the same riskmap, and that's pretty much the case here."

Hampson said that the minor difference between the two ratings may be attributed to the fact that the respective scores had been calculated by her firm a few days apart.

The creditworthiness of the issuer is also taken into account when establishing the riskmap, Hampson noted. "Credit risk may explain the slight difference as well," she said.

The credit profile of HSBC is "slightly better" than that of Barclays, she said, pointing to their respective credit default swaps spreads: 75 basis points for HSBC versus 100 bps for Barclays.

The spread of a CDS is proportional to the risk of default of the issuer.

"Overall, the downside risk as measured by riskmap is fairly similar in both deals," Hampson said.

Probabilities of losses

Hampson then looked at the return ratings, which, on a scale of zero to 10, measure the risk-adjusted return of the notes.

Barclays' notes showed a 4.30 return rating, "a bit lower" than 4.46 for the HSBC product, she said.

"Looking at the probability table gives a good indication of where returns are coming from," Hampson said. "Probability table, riskmap and return ratings are all derived from the same simulation."

"The return rating includes both the downside risk and the potential return. As the downside risk is about the same for both deals, one has to assume that if there is a difference in risk return, it can only be attributed to a difference in potential returns," Hampson noted.

From the probability table of return outcomes published in the firm's reports, Hampson said that the chances for investors of losing more than 5% of their principal were "fairly close" in both deals - a 39.3% probability with the HSBC product versus a 38.5% probability with Barclays' notes.

"Again, the similarity of those two probabilities is due to the fact that the two buffers are the same. The slight difference probably comes from the fact that the notes were rated a few days apart," said Hampson.

Both deals are leveraged and capped buffered notes, a structure that tends to "produce the same dispersion of probabilities," said Hampson.

"You get a big chunk of probabilities for losses of more than 5% of principal and a big chunk of probabilities at the top end," she said.

More of less

However, a closer look at the probabilities of higher returns suggests deeper differences between the two products, Hampson said. She noted that such differences are the result of the way cap and leverage interact.

"[The] HSBC [product] has a 43.8% probability of getting more than 15% in returns because the cap is big enough, while this probability falls to zero with the Barclays [notes]," said Hampson.

But adding the two return buckets ("10% to 15%" on the one hand added to the "more than 15%" bucket on the other hand), Hampson said that the probability of getting a return of more than 10% is 47.7% for the Barclays notes. It was 45.3% for the HSBC product.

While the Barclays notes carry the highest probability of scoring a more than 10% gain, they also carry a lower return rating.

Hampson explained this apparent contradiction by saying, "Barclays has a higher probability of getting more than 10% a year, but your actual return will actually be lower because of the lower cap."

The reverse is true with the HSBC product wherein the return rating is the highest even though the probability of generating an annual return in excess of 10% is the lowest.

"The probability of reaching the maximum return is less because there is less leverage," said Hampson, talking about the HSBC product. "But your actual return will be higher because the cap is higher."

Two formulas

When comparing two leveraged, capped notes, investors need to make a choice between the two formulas. "Do you want a higher potential return but with less probability of earning it, or do you want a greater probability to get the maximum return knowing that it's going to be a lower return?" she said.

Investors who seek a higher potential return with a lower probability need to look for deals structured similarly to the HSBC product, which provide a higher cap but a lower participation rate, she said.

On the other hand, investors who want to increase the odds of earning the maximum return, even at a lower level, should prefer the Barclays notes - that is the product that gives investors more leverage but at the cost of a lower cap, Hampson said.

Very bullish, a bit bullish

"The choice between those two options ultimately will depend on your market assumption," said Hampson.

"If you are really bullish and think the index will be volatile enough to move further, then the HSBC notes represent a better product for you. If you are only moderately bullish and don't think the index movement will be substantial, you may prefer the more leveraged structure, in which case you would do better with the Barclays product."

Hampson gave an example with two different market growth situations.

In a "moderately bullish" scenario, the iShares Dow Jones U.S. Real Estate index fund generates a 5% return over the 18-month term. In that case, the HSBC notes yield a 10% return versus 15% for the Barclays product. In this market environment, investors are "better off" with the low cap and highly leveraged structure offered by Barclays, said Hampson.

In a "very bullish" scenario, assuming that the fund posts a 10% gain during the term and that Barclays sets the cap at 17.6%, the low end of the range, the HSBC notes gain 20% versus only 17.6% for the Barclays product.

In this strong rally environment, investors do better with the HSBC deal that offers less leverage but a higher cap, Hampson said.

Value factor

Hampson said that this structural difference between the two products does not make one superior to another. Rather, the two different types of notes should be seen as two options available to two different types of investors with various levels of bullishness.

Hence the higher overall rating scored by the HSBC notes - 6.94 versus 5.34 for Barclays - should not be interpreted based on the differences in caps and participation rates nor based on riskmap and return ratings, said Hampson.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and risk-return profile.

"Clearly, the value ratings is what makes the difference here," said.

The value rating on a scale of zero to 10 is Future Value Consultants' measures of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

The value rating for HSBC and Barclays is 8.64 and 4.85 respectively.

"HSBC spent more money purchasing the assets and options for the notes than taking on fees and retaining margins, which gives more value to investors," said Hampson.

The HSBC notes are expected to price Feb. 19 and settle Feb. 24.

HSBC Securities (USA) Inc. is the agent.

The Barclays notes will price on Feb. 23 and settle on Feb. 26.

Barclays Capital Inc. is the agent.

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