HSBC's 64.19 million 1% renminbi income notes meet consensus but duration seen as hazardous

By Emma Trincal

New York, May 19 - HSBC USA Inc.'s RMB 64.19 million of 1% Chinese renminbi-denominated notes due May 26, 2016 meets the consensus view that the renminbi will appreciate against the dollar, sources said. But they cautioned about the risks involved as the question is when and to which extent the Chinese currency will rise given China's control over the dollar/renminbi exchange rate.

The notes allow investors to express a bullish view on the Chinese currency as they are denominated in renminbi, with all payments made in dollars, according to a 424B2 filing with the Securities and Exchange Commission.

The spot rate on the pricing date was 6.5108.

Interest is payable semiannually.

The payout at maturity will be par plus the final coupon.

The risk for investors, according to the prospectus, is to be exposed to the depreciation of the Chinese renminbi versus the dollar. If so, repayment of principal at maturity could be less than the initial investment. Investors could lose up to 100% of their investment, the prospectus warned.

In addition, since interest payments are also paid in dollars, a depreciation of the Chinese currency would represent a lower coupon payment, according to the prospectus.

Risk reward

"I don't like the risk return characteristics," said Steve Doucette, financial adviser at Proctor Financial. "For a 1% coupon, you put your entire principal at risk. You might as well play the currency directly. Why tie your principal for five years for 1%?

"No matter how much the coupon may appreciate, I wouldn't get into a risky currency play to collect a coupon."

A global currency strategist at a bank said that the economic consensus has priced an appreciation of the yuan against the dollar but that the question remains when as macroeconomic and political risks increase with the duration of the notes.

Government control

"The economic consensus has priced an appreciation of the renminbi. But problem is the more you extend the term, the more it becomes difficult to price," he said.

Among the risks: the fact that the Chinese government controls the exchange rate of its currency.

The prospectus in its risk section underlines the fact that the Chinese government allows the renminbi to "float within a narrow band with reference to a basket of currencies," and "may use a variety of techniques to affect the U.S. dollar/Chinese renminbi (yuan) exchange."

There is also the possibility, the prospectus warned, that the Chinese government "may issue a new currency to replace its existing currency" or "alter the exchange rate."

The currency strategist said the economic consensus on the renminbi is a 5.82% rise against the dollar in the next two years. On the forward side, the appreciation is priced at 6.18% for 2013.

The non-deliverable forward (NDF) market is also bullish on the yuan long term, he noted.

"Right now, those contracts are pricing an 8.6% appreciation of the renminbi versus the dollar for 2016, the date at which those notes mature," he said.

Very long time

But he said that buying a note may not be the best way to express a bullish view on the renminbi as investors find themselves locked in for five years with little liquidity compared to forward contracts.

"Many anticipate a rally in the renminbi against the dollar in the short term followed by a period of stabilization or crisis. So the end result is difficult to predict. Five years is very long," he said.

"You can make the same bet with a [non-deliverable contract]. Unlike the note, you could trade it and exit your position.

"The idea behind the notes is not bad. But the product scares me a little because my guess is that it could be mispriced."

Institutional bid

Several financial advisers found the trade too risky given the underlying - an exchange rate - as opposed to an index or a fund that offer more diversification.

"It's a pure currency play. There's nothing appealing to me here," said Doucette. "When I invest, I think of global asset allocation. We're not in the business of making bets. We are not betting on individual currencies, individual countries or individual stocks."

Sources speculated that an institutional investor may have been behind the trade given the size of the offering and the specific nature of the underlying bet.

"It was probably for some institutional guy and the deal was structured for him. This is for the high risk, speculative client," said Doucette.

"It's a rifle shot play. It's very specific obviously," a wealth manager said. "I would think it was bought by some sort of institution trying to sell away some risk."

HSBC Securities (USA) Inc. is the agent.

Fees are 1%.

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