HSBC's $40 million knock-out notes linked to Mexican peso drew large bid in carry trade play

By Emma Trincal

New York, Jan. 16 - HSBC USA Inc.'s $40 million issue of 0% knock-out buffer notes due Jan. 28, 2014 linked to the Mexican peso was the No. 1 offering last week as investors continued to seek yield in carry trade plays, sources said. The notes offered investors a bullish bet on the peso against the dollar.

The structure was also seen as attractive for its uncapped upside, minimum contingent return and downside barrier, they noted.

If the peso finished below a 90% knock-out level, investors were fully exposed to losses, according to a 424B2 filing with the Securities and Exchange Commission.

If the peso finished above the knock-out price, the payout at maturity would be par plus the greater of 6.4% and the currency return.

Carry trade

"It's a typical carry trade," a market participant said. "People invested in the notes because the peso has a higher yield than the U.S. dollar. If you get 6.4% in one year, it looks very good."

Mexico has regained favor lately as a hot emerging market, said Clemens Kownatzki, an independent currency and options trader in Los Angeles.

"There's been a rally in Mexican stocks and a rally in the Mexican peso," Kownatzki said.

"A lot of people have realized that Mexico is an underrated country. The location is good for U.S. manufacturers even though the drug war continues to be an issue."

A possible factor behind the bid may have been the structure itself.

"It looks like a good deal because of the upside. I always like deals with an uncapped upside," Kownatzki added.

"There's nothing new with that structure and nothing wrong either," the market participant said.

"But don't forget, if you breach the barrier, you lose money. Compare it with the yield you would get as a peso investor and see if you get additional value. You may or may not be better off with a direct investment in the currency. As long as people understand the risk, it's an efficient way to play the carry trade," this market participant said.

In a carry trade, an investor borrows cheap and lends at higher rates. The yield differential between the peso and the dollar in this note offers the profit opportunity.

Unusual size

A sellsider said that the relatively higher volatility of the peso compared to other currencies such as the dollar or the euro could have also explained the strong bid.

"It's a big size perhaps because people seek value where it is. The peso has seen its volatility increase a little bit, enough to be able to buy the knock-out. Some currency volatilities are higher than others, and the Mexican peso still has volatility," he said.

Yet, this sellsider said he was surprised by the $40 million deal size because in general, investors show little interest in currency-linked notes.

"There's money to be made in currency bets, but I've found that investors typically don't understand those trades," he said.

"They may invest in Mexican equity because somebody told them that Mexico has a positive balance sheet. But nobody understands why the Mexican peso should appreciate versus the dollar.

"The carry trade is not easily explained. The idea that you can simply borrow in a low-yielding currency like the dollar and buy the peso or another type of high-yielding currency is not something investors have been able to get their arms around. That's why you don't see that many currency notes."

But Kownatzki believes things may change.

"There's definitely a renewed interest in FX this year. I'm not surprised to see this type of deal. You're really seeing a shift, part of which is driven by the depreciation of the yen."

The put solution

The bullish notes on the peso do not have a perfect structure, Kownatzki said. The potential breach of the barrier constitutes a risk.

"It's an interesting play. Yes, you have the downside risk, but there is a relatively easy way to deal with it. I would simply watch the situation, and as we get close to expiration I would buy a put option on the peso," he said.

"In 10 months for instance, if you have political turmoil in Mexico, if the downside risk becomes a possibility, you could buy a put. Of course, it would cost you something, but you'd still have the upside, and if the barrier is not breached, you'd still have the 6.4%.

"The upside is really what makes the deal attractive. And if you hedge it with a put, it makes sense."

Part of the downward pressure on the Mexican peso would come from Washington, he said.

"Everyone is looking into the crystal ball: what will happen with the debt ceiling negotiations? Will there be a downgrade? There are two opposite answers to that question. Some believe that a downgrade would be negative for the dollar. Others believe that a real big turmoil would send the dollar soaring in a flight to quality.

"Since it's very hard to tell, you would be better off buying a put toward the end of the term if that's necessary. The deal is still good given the unlimited upside," he said.

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

The notes (Cusip: 40432X7L9) priced on Jan. 11 and carried a 1% fee.

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