HSBC's $35.12 million notes tied to Chesapeake drew high bid due to coupon, sector

By Emma Trincal

New York, Feb. 15 - HSBC USA Inc.'s $35.12 million of 9.5% coupon-bearing notes due Feb. 25, 2013 linked to the common stock of Chesapeake Energy Corp. was the top deal priced last week as investors were attracted to both the structure and the underlying natural gas sector, sources said.

"Natural gas and energy are an area of interest right now, especially natural gas where prices have been historically low and people are expecting them to revert back to more normal levels," a sellsider said.

"The note is a good play in that perspective."

Interest is payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

If the final price of Chesapeake Energy stock is greater than or equal to the threshold value, the payout at maturity will be par of $10. Investors will lose 1% for every 1% that the final price declines beyond the threshold value, 89.74% of the initial share price.

"It's possible an institutional investor may have had a particular view on this stock and thought it was the right time to go in and put this trigger," a market participant said.

"My take is that the buyers must have liked the entry point for the stock and the coupon they could [get] from that note. It was a combination," he said.

Buffered

Unlike many reverse convertibles that build the downside protection around a barrier observable any day with a strike price at the initial level, the structure offered by the HSBC notes buffers the investor from approximately the first 10% losses, the sellsider noted.

"It's a good structure," he said.

"It has a buffer instead of a barrier and that's better. You're getting a hard protection and therefore you're not as much at risk.

"It plays into the need of a buying community that wants protection and income, and we're definitely seeing a trend in that direction," he said.

Reverse convertible

Whether investors get to lose capital once the stock falls below its initial level or below a lower level from which losses start to be felt, the market participant said that the structure was essentially that of a reverse convertible.

"It's very close to a reverse convertible. You get a coupon. You don't get the upside. Your upside is your coupon but you get the downside risk of the equity," he said.

"My definition of a reverse convertible is when effectively you're buying a note where the investor is selling a put.

"Whether the put strike is at the initial price or below does not really change the nature of the structure.

"It may change the terms though as you may get a lower coupon when the strike is lower," he said.

This market participant agreed that income was probably what drove demand for this product.

"A reverse convertible is what people will consider like an income transaction.

"The fact that the notes pay a quarterly coupon could indicate that the investor who bought them was an institutional investor who needed to report quarterly earnings.

"However, it's pure speculation on my part.

"But it's definitely an income play. The stock pays a 1.5% dividend. If you like the stock but not the yield, this may be appealing," he said.

Caution

Mark Hanson, energy analyst at Morningstar who covers the stock, was skeptical.

Investors begin to see their capital at risk if the stock falls by approximately 20%, he said, by adding the 9.5% coupon to the 10.26% buffer amount.

"I wouldn't call the up and down moves of the stock but if you ask me whether it's unlikely that the stock could be down 20% or more a year from now, I would say, not at all. There's a very good chance of that," Hanson said.

"Chesapeake is a very volatile stock, and energy is a volatile sector.

"Natural gas prices are low right now and 85% of this company's production is from natural gas.

"You could see natural gas going even lower in the spring, and Chesapeake would be in trouble if it happens.

"I am bullish on the stock over the long-term but I think within the next year you're going to see some headwinds.

"In addition, they still have a pretty good amount of debt they need to service," he said.

Chesapeake, the nation's second-largest producer of natural gas, is based in Oklahoma City.

Bank of America Merrill Lynch was the agent.

Fees were 1.75%.

The Cusip was 40433K595.

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