HSBC's notes tied to Euro Stoxx offer 30% barrier, no cap but knock-out; index seen as risky

By Emma Trincal

New York, Oct. 11 - HSBC USA Inc.'s 0% knock-out buffer notes due April 16, 2014 linked to the Euro Stoxx 50 index offer bulls unlimited participation in the eurozone equity market with some contingent protection and minimum return. But the knock-out can be triggered any day and the underlying is volatile, two risks which combined may reduce the benefits of a 30% contingent protection and a short duration, a financial adviser said.

A knock-out event occurs if the index falls by more than 30% on any trading day during the life of the notes, according to an FWP filing with the Securities and Exchange Commission.

As long as a knock-out event does not occur, the payout at maturity will be par plus the greater of any index gain and a contingent minimum return of 7.3%.

Otherwise, the payout will be par plus the index return, with exposure to any losses.

Steve Doucette, financial adviser at Proctor Financial, said that he did not feel comfortable with the knock-out because it can be triggered any day during the life of the notes and not just at maturity.

It's only in the absence of a knock-out event that investors benefit from the 30% downside protection and 7.3% minimum return, the prospectus warned.

"Once you hit the trigger, you're just long the index," said Doucette.

American, European

"You're really buying an index with contingent protection. It may be for someone who has a slight bearish view. If you were really bullish, you would want to add leverage to this note rather than just getting the index," he said.

"It's more of a speculative play. I buy the index with this potential contingent minimum return and hope it won't go down by more than 30%," he said.

Overall, Doucette said that the 70% barrier observable on any trading day as opposed to a final barrier was his main concern.

"I don't like those U.S.-knock-outs. I'd much rather have a European barrier," he said.

"You've got 18 months of observation versus one day. That's more risk."

He was referring to the type of options embedded in the notes. American-style options, such as this notes' knock-out, can be exercised any time. European options on the other hand, used with final barriers only get exercised at the expiration or maturity date.

Ups and downs

The volatility of the underlying index added to Doucette's objections to the investment.

The Euro Stoxx 50 index is a blue-chip index for the eurozone. It covers 50 stocks from 12 eurozone countries.

The top country weightings are France (35.1%); Germany (32.8%); and Spain (12.2%).

The index has gained 3.65% year to date, but its chart has displayed a turbulent pattern.

It lost 45% over the past five years and has declined by 17.5% in the last 18 months.

From January to the end of May this year, the index dropped by 13%, hitting bottom in the beginning of June. Since then, the Euro Stoxx has rallied by 18.75%.

Such volatility, according to Doucette, makes the likelihood of a knock-out event occurrence even more likely.

"It's a pretty volatile index. I would have to do more due diligence on it and see the allocation to financials in particular," he said.

Bank and insurance stocks represent 14.3% and 8.4% of the index, respectively.

Low P/E

For others, the growth potential of the eurozone large cap asset class combined with low valuation make up for the risk of getting knocked out.

"The 30% protection level is good relative to the track record and valuation of the underlier," said Matt Medeiros, president and chief executive officer at the Institute for Wealth Management.

"The large caps are very attractive in Europe right now. Even though we're faced with global growth headwinds, the eurozone large-cap companies are trading at much lower multiples than their U.S. counterparts on average,"

Medeiros said, adding that the Euro Stoxx 50 companies have a P/E of 11 on average while the S&P 500 is trading around 16.

The P/E, also called the "multiple" indicates the price investors are willing to pay per dollar of earnings.

"Obviously the U.S. large-cap sector had a nice appreciation throughout the year," he said. The S&P 500 index is up 12% year to date.

"The Euro Stoxx 50 is lagging but can potentially be poised for a similar appreciation assuming the restructuring of the eurozone takes hold," he added.

Valuation and entry points for an investment are just as important factors to consider than the mere terms of a product, he said.

"The advantage of the lower P/E is that the potential of this note hitting the buffer is much less today than it was," he said.

"In 2008 this index went down 50%. The potential of getting down another 30% from now is unlikely.

"Many of the components of the Euro Stoxx 50 are companies that we believe have some growth opportunity. If we are wrong we're less likely to get knocked out with the lower P/E."

Not only was the 30% contingent protection "adequate" given the index valuation, according to Medeiros, but the short tenor also helped reduce the odds of a knock-out.

He pointed to a range of final index return that would enable investors to beat the benchmark in the event that no knock-out has occurred.

"The 18-month term is reasonable. If it went any longer it would change the economics of the deal, possibly the minimum return," he said.

"If it's not hitting the knock-out but not appreciating to the extent of reaching 7.3%, you get a good return for an 18-month. I'd say with the hurdles that we've had, a 7.3% return is fair in today's market.

"What we want is to generate reasonable returns with modest risk. This one would fit the bill," he said.

HSBC Securities (USA) Inc. is the underwriter with J.P. Morgan Securities LLC as dealer.

The notes are expected to price on Friday and settle on Wednesday.

The Cusip number is 4042K17A5.

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