HSBC's notes linked to Industrial Select offer reasonable mildly bullish bet, hedge funds say

By Emma Trincal

New York, May 17 - HSBC USA Inc.'s 0% Capped Leveraged Index Return Notes due May 2014 linked to the Industrial Select Sector index enable investors to bet on a modest upturn in the U.S. manufacturing sector, hedge fund managers said. Whether the product offers the best tool to express this view was a matter of debate.

The structure gives investors two-time leverage on the upside with a partial protection of 10% on the downside.

The payout at maturity will be par of $10 plus 200% of any index gain, subject to a maximum return of 20% to 24%, according to an FWP filing with the Securities and Exchange Commission. The exact maximum return will be set at pricing.

Investors will receive par if the index falls by up to 10% and will be exposed to any losses beyond 10%.

Bank of America Merrill Lynch is the agent.

Retail package

"It seems like a good package product for a retail investor," a New York-based hedge fund manager said.

"Active investing is a lot better, though. But active investing is for professional investors. If you're mildly bullish on industrial stocks and you're a retail investor, this type of package isn't bad."

One of the issues with using a structured note to express a mildly bullish view on the sector, this hedge fund manager added, is the timing of the trade.

"A key to this market is volatility. With the wild swings, do you want to just sit and hold for the next two years? Look at Caterpillar, for instance," he said.

He pointed to the recent share price history of this name, the fourth largest component of the index. The stock hit a low of $70 in October and rose 65% to $115 in February. Since then, it has dropped by 24%.

Steve Mathews, founder of Flintlock Capital Asset Management, LLC, a global macro investment manager, said that the underlying view - modest growth in the manufacturing sector - makes sense.

Cheap energy

"It's not a terrible idea. But these products are needlessly complicated," he said.

For instance, an investor seeking to reproduce the same terms - leverage on the upside, unleveraged downside with protection - could simply lever up two times the equivalent exchange-traded fund and buy puts, he said.

"You wouldn't have to pay a bunch of fees," Mathews said.

The fees are 2%, according to the prospectus.

The Industrial Select Sector index encompasses aerospace, machinery, transportation, electrical equipment and construction and engineering.

Mild growth in the sector seems like a "reasonable thing to expect," he said.

"Industrial stocks have done fairly poorly for an extended period of time," he noted.

The corresponding ETF, which is listed under the NYSE Arca ticker symbol "XLI," is up only 1.5% year to date. It has lost 7.5% over the past 12 months.

"It would be bold to call for a rapid growth, but at the same time, you see encouraging signs," Mathews said.

"If we see a continuous stimulus, if there's a QE3, then you can certainly expect growth.

"Plus energy in this country is incredibly cheap, which will help the sector.

"We're increasing our production of energy in the U.S. while demand is not rising.

"With cheap energy here and increasing difficulties in China, you can see manufacturing in the U.S. improving in the near future."

Bargain-hunting

The other hedge fund manager said that he is now buying industrial stocks in the hope that a new round of monetary stimulus is underway.

But his main motive is the deeply discounted valuations found among names in the industrial sector.

"I'm the least bullish I've been for a while, but I'm still buying. Everything points to Europe, and with the euro zone crisis, machinery is getting decimated. We have a correction and therefore, we're getting significant discounts. You look for value knowing that you're throwing out value until we get a resolution in Europe. Things are trading at lower multiples. There are bargains out there," he said.

However, he said that he is implementing his stock picks with full liquidity, a benefit not available to investors in the note.

The product is expected to price in May and settle in June.

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