HSBC's Stars linked to S&P 500 reduce reinvestment risk with six months of call protection

By Emma Trincal

New York, March 9 - HSBC USA Inc.'s 0% Strategic Accelerated Redemption Securities due March 2013 linked to the S&P 500 index offer investors an attractive risk/reward profile while reducing reinvestment risk, said structured product analyst Suzi Hampson with Future Value Consultants.

The one-year autocallable product is structured around quarterly observation dates, but one date - the first one - is eliminated, making the notes callable at six, nine and 12 months after the pricing date and not at three months after, according to an FWP filing with the Securities and Exchange Commission.

Hampson said that one of the main risks incurred by investors in autocallable products is the uncertainty of the duration. "You don't know if and when you will be called, and you get compensated for that with the premium," she said.

If the index closes at or above its initial level on one of three observation dates, the notes will be called at par of $10 plus an annualized call premium of 7% to 11%. The observation dates will be in September 2012, December 2012 and March 2013.

If the notes are not called and the final index value is at least 95% of the initial value, the payout at maturity will be par. Investors will be exposed to losses beyond the 5% buffer.

Bank of America Merrill Lynch is the underwriter.

First call

"People have to be prepared for an early exit when they buy those products," she said.

"And the probabilities of getting kicked out are always the highest on the first call date.

"If you're not kicked out on the first observation date, it means that you're below the original price. Therefore it will be harder for you to get kicked out on the following call date since you'll have to go from negative to positive."

Hampson explained that in the United Kingdom, issuers came up with a device aimed at reducing the high probability of a call on the first observation date.

"In the U.K., you see these kick-outs with decreasing trigger levels. It could be a call level of 100 on the first year, then 95 on the second, etc. It's a popular trend. It's done so that the probability of the autocallable does not necessarily decline with time," she said.

Six months without call

The notes offer investors six months of call protection, which may be appealing for investors who want the income benefit of the structure without having to deal with the reinvestment risk too soon.

"With this product, you're the most likely to get the call in six months. That takes care of a lot of the reinvestment risk. Some people don't want to have to manage their investments every month or every quarter," she said.

Clipping the coupon

Not every investor seeks the early redemption, she added.

While the annualized rate of return is the same regardless of when the call is triggered, some investors would rather accumulate as much as possible in actual return, she said.

The premium will be between 3.5% and 5.5% if the notes get called on the first observation date, six months after issuance. It will grow to between 5.25% and 8.25% if called after nine months and between 7% and 11% if the call is triggered at the end of the term, on the final observation date.

A call after three months, if it had been included in the terms of the deal, would have generated a much smaller payout of 1.75% to 2.75%, said Hampson.

"This reduction of the number of call dates is not that common in the U.S.," said Hampson.

"We see it more in the U.K., where all products in general have longer maturities.

"The typical autocallable in the U.K. would carry a five-year maturity with no call for the first year."

Riskmap

Future Value Consultants measures the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the score, the riskier the product.

The 3.19 riskmap for this product is lower than the 4.48 average riskmap for other autocallable products. It's even less than the 4.65 average riskmap of all products.

"A lot of autocallables are tied to single stocks. The S&P 500 used in this product is one of the less volatile compared to stocks or emerging markets," she said.

"You also have a 5% buffer. That gives you an advantage compared to the all-products category, where many deals don't offer any protection at all."

The riskmap is composed of a market riskmap and a credit riskmap.

The product carries a very low market riskmap of 2.65 versus 3.92 for other autocallables.

"Again, having an index instead of a stock reduces the volatility a great deal; as a result, there is a lower chance of breaching the barrier," she said.

Return score

Future Value Consultants measures the risk-adjusted return with its return score on a scale of zero to 10.

The product received a 6.59 return score versus 6.34 for other autocallables.

When compared to the 6.43 average score of all products, the notes fare better as well.

"The return score is above average. It's not a huge difference, but it shows that given the same amount of risk, this product offers good returns [compared] to others. You have a smaller buffer that may have elevated the return you're getting," she said.

"However, the 7% to 11% payout in the prospectus is a huge range. Things could change if the final call premium was 11% or 7%."

For the calculation of its scores, Future Value Consultants picks a payout at 75% within the range, which would be 10% for this product, she said.

The return score is derived from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

The performance is modeled based on a series of parameters, which include volatility, dividends and interest rates among others.

The probability table associated with this product reveals a 73.6% probability that investors will generate an annual return comprised between 10% and 15%. The chances of losing more than 5% of principal are 10.6%.

Value, overall

The product also offers good value, said Hampson.

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

The notes have a 7.58 price score, slightly above 7.24, the average score for products of the same structure type.

Future Value Consultants' opinion on the quality of a deal is measured by the overall score, which is the average of the price score and the return score.

Scoring 7.09, the notes offer a higher overall score than their peers, which have a 6.79 average score. The average overall score for all products is also lower at 6.68.

"This is still a capital-at-risk product. But it's designed for someone who wants a fixed return based on a low-growth expectation. If you believe that the market will be flat for a year, you'll be better off with a 10% return rather than buying a participation note," she said.

The notes are expected to price and settle in March.

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