HSBC's income opportunity notes due 2014 linked to 10 stocks target conservative yield-seekers

By Emma Trincal

New York, Nov. 29 - HSBC USA Inc.'s annual income opportunity notes with auto cap due Dec. 29, 2014 linked to a basket of 10 common stocks give conservative investors full principal protection with a relatively short duration and more income potential than a traditional certificate of deposit, a market participant said.

On the other hand, the coupon is variable, capped and based on the performance of an underlying basket of stocks, subjecting the income amount to market risk.

The basket includes Altria Group, Inc., Amazon.com, Inc., Amgen Inc., Archer-Daniels-Midland Co., AT&T Inc., Barrick Gold Corp., General Mills, Inc., Halliburton Co., Intel Corp. and Mattel, Inc., according to an FWP filing with the Securities and Exchange Commission.

Interest is payable annually and will equal the average of the performances of the basket stocks, subject to a minimum interest rate of 0%.

A stock's performance will be equal to the auto cap rate if its return is zero or positive. The auto cap rate is expected to be 5% to 7% and will be set at pricing. If a stock's return is negative, its performance will be the greater of its return and negative 30%.

The payout at maturity will be par.

Sideways view

"The vast majority of income-generating trades that we do utilize digital options or auto cap like this one," a market participant said.

"We think it offers great value for investors who see the market moving sideways over time.

"If you think the market will move upward but not sharply, the auto cap presents an opportunity to capture an attractive return."

The notes are designed for investors who seek full repayment of principal at maturity, according to the prospectus. Many such investors tend to invest in CDs, said the market participant, who also offers CDs to his clients.

Funding

"One of the advantages of this over a CD is the three-year term. You get a higher potential return for a shorter term," he said.

He explained the difference in potential income between those two products: "HSBC is using its corporate funding for these notes versus its bank funding for a CD. It's the corporate spread versus the Libor spread."

Another factor has to do with funding.

"It's just a guess, but given the current environment, there is a preference to fund the shorter end of the curve due to the market uncertainty," this market participant said.

"They may want to fund in the three-year space, and that's maybe why they're more aggressive on this end of the curve."

Arithmetic average

Lee Kramer, president of Capital Management Analytics, said that the structure of the notes subjects income seekers to market risk while limiting the upside to the auto cap.

The arithmetic average of the performances of all the reference stocks could be as low as negative 30%, the floor level, and not higher than the 5% to 7% auto cap.

"If one or two stocks did very poorly from the start, say they're down 30%, they could continue to be a drag since it's not reset every year. They go with the initial level," Kramer said.

"And if one stock soars 40% on year one, you're capped at 5%," he said.

Compared to a CD, investors in the notes have to be comfortable with the creditworthiness of HSBC, according to the prospectus.

HSBC USA is rated AA- by Standard & Poor's.

But unlike a CD, Kramer noted, the notes do not offer a fixed coupon payment. Instead, the interest is calculated based on a formula that caps the upside and put the investor at risk of not earning any interest if the average performance is negative.

Vanilla appeal

Income-seekers could easily find better alternatives in today's volatile market as corporate bond yields have been on the rise as a result of the European sovereign debt crisis, Kramer said.

Kramer said that he is "very comfortable" with HSBC as a "credit risk," but so is any investor in these notes or any investor in HSBC's senior debt, he noted.

"A three- to four-year HSBC conventional debt can yield as much as 4%. So as an investor I'd rather take a sure 4% than a note with stock risk that may pay at most 5% to 7%."

The European debt crisis provided higher yield opportunities that did not exist until recently, making the returns offered in structured notes relatively less appealing than what they were before.

"In my opinion, the market is very skittish about A and AA rated European bank issuers such as HSBC, and as a result the yields on their senior unsecured debt are very elevated right now compared to U.S. Treasuries," he said.

"In more normal times short-term HSBC debt would not trade with yields this high and the relative upside potential of this structured note may have been appealing to investors looking for conservative exposure to a basket of stocks.

"But today the extra potential yield of a structured note like this one is very small compared with just buying a conventional debt obligation, so an investor might ask 'Why bother?'"

The notes (Cusip: 4042K1TD5) will price Dec. 23 and settle Dec. 29.

HSBC Securities (USA) Inc. is the agent.

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