HSBC's knock-out buffer notes linked to palladium for bulls late in the rally, source says

By Emma Trincal

New York, April 19 - HSBC USA Inc.'s 0% knock-out buffer notes due May 3, 2012 linked to the price of palladium are for investors who want to cautiously play the end of a long bull market for the industrial metal, sources said.

The notes limit the upside but also ensure some minimum return if a knock-out event fails to happen within the one-year term.

If palladium declines by more than 20% during the life of the notes, the payout at maturity will be par plus the palladium return, which could be positive or negative, according to an FWP filing with the Securities and Exchange Commission.

Otherwise, the payout will be par plus the greater of the palladium return and 7.25%.

In either case, the payout will be subject to a maximum return of 20%.

The notes (Cusip: 4042K1GM9) will price April 26 and settle April 29.

J.P. Morgan Securities LLC is the agent.

Moderately bullish

"The idea is I'm going to get 7.25% in return for palladium prices trading anywhere from down 19.99% to plus 7.24%," said Brad Zigler, research analyst at Hard Assets Investor.

"If I'm not really bullish, that's my opportunity here. There is a rationale given the trajectory that palladium has had and the sentiment that emerging market countries will still need cars. You could say 'I'm late in the rally, the big money has already been made,' but there may still be more money to get at this later stage of the bull run."

The bull market for palladium has to do with the rise of emerging market economies, especially China, and is directly related to the growing use of this metal for automobile catalytic converters, he said.

"The buoyancy in the palladium market comes from emerging markets," he said.

Very volatile

However, prices have not just gone up. "Palladium is extremely volatile," said Zigler.

In November 2008 for example, palladium traded at $160 per ounce. It reached $860 in February, its highest level on record, said Zigler. Two months later, the price is down $100 at $760.

The last correction was in May 2010 when prices fell 30% in just one month to $400, he said.

"Palladium volatility is real. It's a very volatile metal and, until recently, a terribly illiquid one to trade," he said, adding that palladium futures became more liquid after the recent creation of related exchange-traded funds.

Resilient rally

So far, investors bullish on palladium have been right, he noted.

"Although palladium is volatile, if you look at the rally's trajectory since November 2008, it's been unbroken toward the upside.

"When you get so much upward momentum, the market is usually overextended. Demand is just advancing too fast, and eventually you run out of buyers.

"But unlike gold, palladium can remain overbought for a long time."

This may lead even more bullish investors to be attracted to the notes. But for them, the drawback would be the cap, he said.

"I'm capping my upside at 20% for a 7% guarantee in the course of one year. You'd have to say 'Well, that's better than a sharp stick in the eye, but it's certainly not going to make me rich.'"

A prudent investor, he added, may prefer to wait for a market sell-off, and he recommended keeping an eye on the 200-day moving average, which is currently $670.

"Given the volatility of palladium, a 20% drawdown in its price is eminently possible," he said.

But the downside risk involved with the notes is no greater than the risk faced by investors in the ETF, he said. "It's even less risk than a futures position because with futures you trade on margin and you could lose more than what you invested in," he said.

Alternatives

Still, Zigler said that the trade could be replicated using a combination of options and futures.

"Depending on what your goal is, on what the option market makers are willing to offer to you and your level of sophistication, you have a myriad of solutions.

"You could do better purchasing the metal and buying a call spread.

"The investment bank is creating a synthetic option position and packaging it for you.

"If you're not well versed in options, it's obviously a simpler solution."

'Too rich'

Matthew Bradbard, president of MB Wealth, said that he thinks the palladium market is due for a correction.

"I wouldn't touch it. Palladium has gone up by 500% in the last two years. It's overbought," he said. "And on the downside, you could easily get knocked out at 20%."

But he agreed that it's hard to say when a correction will occur for commodities that trade on momentum as palladium does.

"Everybody is buying it, but everybody is generally wrong.

"Not that I didn't get silver wrong. I thought silver was too rich and I was dead wrong. It's been trading up on momentum, and whoever stayed in silver made tons of money. So who knows if this could happen with palladium? But to me, it's just too rich. I wouldn't buy it at those levels."

JPMorgan deals

Tapping into the high rise in the popularity of palladium, JPMorgan, the agent for this deal, sold three very similar deals this month for Barclays Bank plc and Deutsche Bank AG, London Branch. They all had the same one-year maturity with a 20% knock-out on the downside and a 20% cap on the upside. The minimum contingent returns varied.

Barclays priced $12.08 million of 0% capped market plus notes due April 26, 2012 with a 8.15% minimum return.

Deutsche Bank priced $12 million of 0% capped knock-out notes due April 18, 2012 with a 7.5% contingent minimum return.

Deutsche Bank priced $32.02 million of 0% capped knock-out notes due April 13, 2012. The contingent minimum return was 9%.

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