HSBC's coupon-bearing notes tied to Qualcomm via Bank of America show value, good risk/return

By Emma Trincal

New York, Aug. 17 - Sometimes, a reverse convertible with uninspiring terms may hide a decent risk/return profile as well as good value, but investors need to pay attention to the implied volatility of the underlying stock, said Gurdeep Ubhi, structured products analyst at Future Value Consultants.

Such is the case with HSBC USA Inc.'s upcoming coupon-bearing notes due August 2013 linked to the common stock of Qualcomm Inc., which do not deliver a very high coupon or a great deal of downside protection, he added.

Interest is payable quarterly at the rate of 7.5% per year, according to an FWP filing with the Securities and Exchange Commission.

If the final price of Qualcomm stock is greater than or equal to the threshold value, 94% to 98% of the initial value, the payout at maturity will be par of $10. The exact threshold value will be set at pricing.

Investors will share in losses beyond the threshold value.

Making the assumption of a 4% buffer for this product and looking at the average 80% barrier seen for similar structures, Ubhi said that a comparison is hard to make.

"If you compare a barrier with a buffer when both have exactly the same level, yes, you can say that the buffer is always better. But this 4% buffer is much smaller than your average 20% protection from a barrier. So there is no direct comparison with this one," he said.

"However, you can still see that the 16% difference between 4% and 20% will give you with the barrier much more range of movement. So you can conclude that this product offers less downside protection than the average reverse convertible. But of course it's all relative to the stock.

"Similarly, the 7.5% coupon is not much compared to 8.8%, which is the average we have recorded in July for reverse convertible coupons."

Volatility

Ubhi said that investors in reverse convertibles should always look beyond the terms of the note.

"What makes the difference between this product and your typical reverse convertible is the volatility of the stock. It is a big risk-reducing factor, which explains why you're getting a lower coupon and less protection. The lower volatility is unusual for this type of product and contributes to diminish the chances of losing money," he said.

The one-year implied volatility of Qualcomm shares is 22% versus about 20% for the S&P 500, he noted.

"It's not much. Most reverse convertibles are based on much more volatile stocks. This is why this note is not typical.

"It's actually close to the volatility of an index, and you don't see reverse convertible tied to indexes simply because there is not enough volatility to show marketable coupons.

"What is working for this product though is precisely the lower-than-average volatility. The investor would have to do his homework. Qualcomm is not as volatile as the average stock. So your terms are going to look different than the typical reverse convertible. There is a logic to it.

"The typical reverse convertible has much more volatility embedded to it with a higher coupon. This one doesn't have that. But it offers a less risky profile due to the underlying stock," he said.

The impact of a lower volatility in the underlying stock is reflected in the risk profile of the product as measured on a scale of zero to 10 by Future Value Consultants' riskmap. The 2.91 riskmap for the notes is lower than the 4.31 score for the average reverse convertible.

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

The market riskmap is also less for the notes at 2.22 against 3.73 for reverse convertibles in general.

"Again this is due to the volatility," he said.

On the other hand, the credit riskmap is slightly higher at 0.69 than that of comparable products at 0.58.

"The difference is not huge and comes from the longer duration. Reverse convertible are in the three, six, 12 month mix. The longer ones will have a higher credit risk, and this one is a one-year," he said.

Risk versus return

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The product has a 6.49 return score versus 6.10 for the average of reverse convertibles.

"The score measure the risk/return profile, not just one or the other," he said.

"Although they're not offering as high a coupon as the average, there is less risk of losing money due to the low volatility.

"This particular reverse convertible has an unusual risk/reward profile. Most investors in reverse convertibles want an eye-catching coupon. They take the high-risk, high-return route. That's the rationale for reverse convertibles. They are high equity risk. It's not the case with this one."

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the five key assumptions. It assigns a probability of return outcome to each of the payoff buckets.

The chart is generated using a Monte Carlo simulation using various parameters such as volatility, dividends and interest rates.

When using the neutral assumption, which is a risk-free growth scenario, the notes show a 13% probability of leading to a loss of more than 15% per year. However, there is a 67% probability of generating a gain in the 5% to 10% bucket.

The dispersion in probabilities between gains and losses is two-thirds and one-third, respectively.

Price, overall

Future Value Consultants measures the market value of the underlying components of the product with its price score on a scale of zero to 10. Calculated as a percentage of the initial investment, the score gives an estimate of the fees taken per annum. The higher the score, the lower the fees and the greater value offered to the investor.

The notes scored 7.29 on the price scale versus 6.64 for the average reverse convertible.

"The vast majority, almost all reverse convertibles are linked to riskier stocks. This note offers value for your dollars. It gives you a decent coupon and not as much downside risk compared to other products," he said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

The overall score is 6.89 for the notes, compared with an average 6.37 overall score for the same product type.

"The issuer here offers you a more stable product with less protection and less income. You just have to know about the stock. If you look at just the terms, you wouldn't go for that. If you don't pay attention to the volatility, then sure, this product is not attractive. But if you look under the hood, there are reasons behind the terms and you can actually find something with good value and a decent risk/reward profile," he said.

The notes are expected to price and settle in August.

Bank of America Merrill Lynch is the underwriter.

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