HSBC's knock-out buffer notes linked to currency basket offer bullish bet on global recovery

By Emma Trincal

New York, Feb. 22 - HSBC USA Inc.'s 0% knock-out buffer notes due Sept. 3, 2013 linked to the performance of a basket of currencies relative to the U.S. dollar offer attractive upside for investors bullish on the global economy, said Mark McCormick, currency strategist at Brown Brothers Harriman.

The underlying currencies are the Brazilian real, the Mexican peso and the Canadian dollar. They are equally weighted.

"These are high-beta currencies related to economic growth and pretty sensitive to the fluctuations in equity markets," said McCormick.

"You want to be bullish on this basket if you think that the global economy is improving."

Global recovery bet

The notes provide the opportunity to participate in the appreciation of the basket at maturity giving investors par plus the greater of the basket return and a contingent return set to be at least 12.5%, according to an FWP filed with the Securities and Exchange Commission.

However, if a knock-out event occurs, investors will be fully exposed to losses. The knock-out event occurs if the basket is less than 80% of the initial basket level on the final valuation date.

"There is a tail risk for owning high-beta currencies, and you can't completely rule out a decline of 20% or more in 18 months," McCormick said.

"But the outcome is more in favor of those currencies appreciating in that timeframe.

"Greece exiting the euro zone would probably disrupt that type of trade. But if Greece stays in the euro zone and if we see Europe kicking the can further down [the road], that kind of trade might actually pen out if the economy continues to stabilize."

The notes allow investors to outperform the basket if the final performance is anywhere between a 20% loss and a 12.5% gain, according to the prospectus.

In this return range, the knock-out event has not occurred and investors automatically get the contingent minimum return of 12.5%.

Full downside exposure

The securities, however, do not guarantee any return of principal, and investors can lose up to 100% of their capital if a knock-out event occurs, the prospectus warned in its risk section.

It is a concern for some advisers, such as Andrew Valentine Pool, main trader at Regatta Research & Money Management, who pointed to the risk of severe losses.

"The upside sounds really good with no cap and a contingent minimum return," he said.

"What's not so good is the fact that you don't have a hard buffer that would guarantee some percentage of capital and would make you lose one for one from there.

"If the basket is down 28%, the client is down 28%. That's how you lose a client. You don't lose a client because you don't make a lot of money but because you lose too much money.

"For us, the upside potential of this trade is not worth the risk. There's too much turmoil all around. ... The Middle East, what a speed bump that is! I think we would take a pass on that."

Several of the recently priced FX-linked notes offer generous levels of downside protection, some giving as much as 90% to 100% protection on the downside, according to data compiled by Prospect News.

For instance, Bank of America Corp. earlier this month priced $15.23 million of 0% Currency Market Index Target-Term Securities due Feb. 4, 2014 linked to the Chinese renminbi/dollar exchange rate measure. The payout at maturity will be par plus 130% of any increase in the value of the exchange rate measure. The payout will be par if the exchange rate ends up negative.

A currency structurer said that JPMorgan has no difficulties selling products such as the upcoming HSBC notes.

"JPMorgan does a lot of those non-principal protected FX deals," this structurer said. "They put together a short-term product with a basket of currencies and full downside exposure.

"It's not the first time, and for their client base, the absence of full principal protection seems to work well. We just don't do that. We only price currency structures with 95% to 100% principal protection."

The HSBC notes (Cusip: 4042K1XV0) are expected to price Friday and settle March 2.

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

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