HSBC's notes with sticky cap tied to 10 stocks may be cheaper to hedge, offer better terms

By Emma Trincal

New York, March 8 - HSBC USA Inc.'s six-year notes paying a coupon annually with a sticky cap linked to a stock basket represent an unusual and possibly more cost-efficient way to structure a principal-protected product, sources say.

HSBC plans to price annual income opportunity securities with sticky cap due March 31, 2016 linked to a basket of 10 common stocks, according to an FWP filing with the Securities and Exchange Commission.

The basket includes AT&T Inc., Chevron Corp., Chubb Corp., Coca-Cola Co., Fedex Corp., Ford Motor Co., Gilead Sciences Inc., Oracle Corp., Praxair Inc. and Sempra Energy.

Interest is payable annually and will equal the average of the returns on the basket stocks, subject to a floor of zero and a sticky cap of 7% to 8% that will be set at pricing.

If on any coupon valuation date the return for any stock is equal to the sticky cap, the return for that stock will be set at the sticky cap for each succeeding valuation date, regardless of the stock's actual performance.

The payout at maturity will be par.

Something different

"It's quite unusual. Normally, you see structures in which investors get paid at maturity. The payout is based on the underlying return of the reference asset subject to a cap," said Suzi Hampson, structured products analyst at Future Value Consultants. "It would be interesting to price this deal with and without the sticky cap to see how valuable it is for the investor."

A sellsider said that this structure is different than most principal-protected notes because it pays an annual coupon. "Typically, you have a cap at maturity, not year after year. You look at the performance point to point, from the initial pricing to the end of the term," he said.

In addition, data compiled by Prospect News shows that principal-protected notes are rarely linked to a basket of stocks. In most cases, the underlying is either a stock index or a basket of indexes. In other cases, the underlying basket comprises currencies or commodities.

As with other principal-guaranteed products, the structuring of the HSBC notes will require combining a zero-coupon bond that will mature at par with the purchase of a call option, said Hampson.

The issuer buys the call in order to be able to pay up to the capped return if necessary.

The difference between the notional and the cost of the zero-coupon bond is what will be left for the issuer to purchase the call, Hampson said. Usually, she noted, issuers lower their cost by extending the duration of the notes.

But the sellsider said that the annual coupon structure offers the issuer an alternative way to lower the cost of the option.

Cheaper hedge

"The call must be cheaper here because I don't think I can get principal protection on a basket of stocks with a six-year maturity," the sellsider said. "It's cheaper to purchase the call in this deal because they pay for it on a yearly basis rather than point to point. That's how they get those terms. A 7.5% cap is not bad at all for an annual payment."

"The general rule is that the issuer looks for cheap financing. If it's less costly to hedge, they can offer an apparently higher rate," said a financial adviser.

However, this adviser said that he probably would not show the notes to his clients because he found the structure to be "fairly complex."

An options expert said that the annual evaluation of the cap makes the purchase of the option cheaper and therefore offers a more cost-efficient hedge for the issuer than when the option is bought for the entire term.

Assuming that the sticky cap is set mid-point at 7.5%, Lillian Seidman-Davis, senior options strategist at Miller Tabak, said, "The issuer has to buy every year a call with a 7.5% strike price. It's cheaper because they don't have to pay out the call upfront for the entire six-year term. In addition, they don't have to take on several years of volatility risk or interest rate risk all at once. They break down the risk and the cost, buying it year after year. It's very interesting."

Complexity cost

While the structure is cost-efficient for issuers and its terms attractive to investors, principal-protected notes tied to a basket of stocks that offer annual coupons contingent upon the basket performance with a sticky cap are not seen very often, said the sellsider.

"Investors are subject to the risk of missing out on the high performance of one or several of the stocks, because once you hit the sticky cap, you're locked in. But that's the price you pay for principal protection," he said.

Perhaps more importantly, he noted, what may limit the popularity of these types of products is the annual coupon.

"These structures are not always popular because most clients like point to point. At the end, it's very easy to understand and it's perceived as being more transparent," the sellsider said.

"If you can understand and explain these products to your clients, you may have an easy sale. It's my experience that broker-dealers always prefer something easy to explain. That's probably the reason I haven't seen a lot of demand for principal-protected notes paying an annual coupon with those types of caps," he said.

The securities will price March 26 and settle March 31.

HSBC Securities (USA) Inc. is the agent.

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