HSBC's digital notes tied to Dow offer attractive risk vs. return with buffer, uncapped upside

By Emma Trincal

New York, Feb. 17 - HSBC USA Inc.'s 0% buffered performance plus securities due Aug. 27, 2015 linked to the Dow Jones industrial average offer an attractive risk/return profile as they combine a 20% buffer with a digital payout and no upside cap, said Gurdeep Ubhi, structured products analyst at Future Value Consultants.

If the index finishes at or above its initial level, the payout at maturity will be par plus the greater of the index return and 16%, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 20% and will lose 1% for every 1% that it declines beyond 20%.

Accelerated growth

"The 16% digital payment is an accelerated return since you receive it even if the index ends up flat. It doesn't have to grow," Ubhi said.

"This product offers exposure to a quite well-known equity benchmark to an investor looking for some protection. You get the protection with a 20% buffer, which is not bad.

"Finally, your upside is unlimited, which makes the structure particularly attractive in terms of potential return."

The product is rated in comparison to all products recently reviewed by Future Value Consultants as well as products that have similar structures. In this case, the peer category is digital payout notes.

"In the same type of products category, you could get notes that give you the digital payout if the index finishes above the initial level like here. Or in some cases, it would be if it ends lower but above a certain threshold, like 80 for instance if the initial price is 100," Ubhi said.

"The difference though is that you have here the unlimited upside combined with the partial downside protection.

"You could get something like that with a higher digital payout than 16%. But it may not have a buffer. And if you had a buffer, you may have your upside capped.

"A lot of accelerated growth products are capped. Principal-protected notes are capped. Reverse convertibles are capped.

"This one has no cap and a buffer. It makes it relatively attractive."

Outperforming the Dow

Ubhi compared the risk/return profile of these notes with a direct investment in the benchmark.

"On the downside, you'll always outperform the index because you have the 20% buffer," he said.

"On the upside, as long as the Dow Jones closes below 16% at maturity, you're going to outperform the index too. If it goes above 16%, the product turns into a tracker."

One of the main differences with a direct investment in the equity benchmark is that investors in the notes will not receive dividend payments, he said, a characteristic common to most structured products.

"A slightly more bullish investor may prefer a higher digital payout with a smaller buffer. Others may prefer a structure with leverage or a shorter term than three and a half years," he said.

"It depends on what your market view is. If you're a bit cautious but think the index is going to grow, you want the buffer and you want the accelerated payout if it does move. In that case, yes, this is a good deal."

Less market risk

The product has a lower-than-average risk level as evidenced by its riskmap, a Future Value Consultants rating that measures the risk associated with a product on a scale from zero to 10.

At 3.44, this product's riskmap is less than the average of all products (4.75) and also lower than 4.56, the average of similar digital notes.

"It's clearly the buffer. A 20% buffer is a decent buffer. You're comparing this product with others that do not have any buffers or they may have smaller buffers or barriers rather than buffers," he said.

"Also, the Dow Jones is not a very volatile underlying. When you compare this to all other products, you have a great deal of notes tied to single stocks in the reverse convertible category, which of course is much more volatile," he added.

The riskmap is the sum of two risk components: market risk and credit risk.

For these notes, the 2.24 market riskmap is significantly less than the average market riskmap of all other products, 4.12, and of similar products, 3.47. Both factors - the buffer and low volatility - are at play, he noted.

The 1.19 credit riskmap is greater than that of all other products due to the duration of the notes.

"You take the credit risk of HSBC for three and a half years. It's more risky than if you took if for three months or a year," he said.

On the other hand, the credit riskmap gap between this product and its peers is narrower: 1.19 versus 1.09, respectively, but the duration remains the explanation.

"A lot of the similar digital products have similar maturities and similar returns. They're also tied to less volatile indexes, which is why they tend to be longer," he said.

Risk/return profile

Future Value Consultants measures the risk-adjusted return of a product with its return score. Established on a scale of zero to 10, it is calculated under reasonable and consistent forward-looking assumptions.

In the calculation of the return score, Future Value Consultants use five key assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. The firm calculates a risk-adjusted average return for each assumption. The return score is the best of these five returns.

The notes received a high return score of 8.13, more than 6.44, the score for all products, and better than the return score of similar products, 7.38.

"The product has a buffer, and it offers an uncapped return. You can benefit from the full appreciation in an exceptional-growth scenario," he said.

"The uncapped element is quite key to explain the high return score."

Reverse convertibles outnumber other structures, and they are capped by the coupon amount. This explains why this product offers a higher return score than the all-product average, he said.

The high return score means that the return investors may get is high compared to the risk they are subject to.

For this product, the best market assumption would be a high-growth scenario, explained Ubhi, who said that for investors, the best-case scenario is if the index closes above 16%.

Probabilities of returns

Future Value Consultants produces several probability charts that show how the product is expected to perform.

When using the neutral assumption, which is a risk-free growth scenario, the notes show a 41% probability of generating an annualized return of zero to 5%. This return bucket corresponds to the payment of the 16% digital coupon over the period, or about 4.5% a year.

There is a 9.5% probability of losing more than 15% of principal.

Under the optimal assumption of high growth, however, the 0%-5% gains bucket has only a 28.8% probability of happening while the chances of losing more than 5% are reduced to only 5.2%.

Price, overall

The notes have a price score of 7.91, comparable to their peers. The average score for similar products is 7.89.

The price score is Future Value Consultants' measure on a scale of zero to 10 of the real value to the investor after deducting on an annual basis the costs the issuer charges in fees and commissions.

"The two scores, this product versus its peers, are quite similar because it's always a trade-off between the cap level and the amount of protection," he said.

However, the price score for the notes is characteristically higher than the average price score of all products, which is 6.91.

"You have value in this product. It's not really a volatile index. It offers a decent protection, and you have an uncapped upside. That's why you have a high price score," he said.

Future Value Consultants offers its opinion on the quality of a deal with its overall score, which is the average of the price score and the return score.

Because the return score is much higher than other products, the overall score for these notes, at 8.02, is above the 6.67 average.

HSBC Securities (USA) Inc. is the agent.

The notes will price on Feb. 27 and settle on Feb. 29.

The Cusip number is 4042K1XM0.

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