HSBC's leveraged barrier notes linked to Asian indexes offer narrow bet on Far East ex-Japan

By Emma Trincal

New York, Oct. 7 - HSBC USA Inc.'s 0% performance barrier notes due May 1, 2017 linked to a basket of equally weighted indexes provide investors with emerging markets exposure but with a concentration on Far East Asian countries excluding Japan, sources noted.

The underlying indexes are the Hang Seng China Enterprises index, the Korea Composite Stock Price index 200, the MSCI Taiwan index, the Hang Seng index and the MSCI Singapore Free index, according to an FWP filing with the Securities and Exchange Commission.

The Hang Seng is the Hong Kong stock market index. The Hang Seng China Enterprises index is comprised of H-shares listed on the Hong Kong Stock Exchange tracking the stock performance of Chinese companies that trade in mainland China.

The payout at maturity for the notes will be par plus at least 120% of any basket gain. The exact leverage amount will be set at pricing.

Investors will receive par if the basket falls by up to 25% and will be fully exposed to the decline if it drops below the 75% barrier level.

No laggards

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he likes the combination of countries included in the underlying basket.

"It's a nice note. It gives you exposure to emerging markets, but you're getting exposure to the emerging markets that are actually working - it's not India or Brazil. It focuses on countries that are putting out good numbers," he said.

"Singapore is doing well. Korea is doing fantastic. China has seen its growth go down, but their GDP is still growing at 6% to 7% while we're growing at 2%. And if you take into account that the U.S. economy is 10 times bigger, you get a better sense of how much their growth really is. You have to take it from a relative perspective."

Kunhardt said that should he invest in the notes, he would use it as part of his emerging markets exposure within a particular bucket of his alternative investments allocation that he calls "enhanced growth."

The asset allocation process for him begins with "asset types," which are cash, fixed income, equities and alternative investments.

Within the alternative asset class, he said that he uses several buckets. One is real estate; a second one is "hedge strategies," which are ways to use "non-correlated assets to lower the overall volatility" of the portfolio. Some of the strategies in that category would include long/short strategies, global macro funds and arbitrage. Fixed-income replacement is part of the same bucket.

"I am trying to reduce my bond exposure given the risk associated with the current market and the potential for rising interest rates," he said.

Finally, the third bucket would be what Kunhardt called "enhanced growth," which would include managed futures, commodities and currencies.

Alternative investment

"This note would fit into my alternative asset type, like all my structured notes. By definition, those notes are derivatives, so they go into that part of the portfolio by default," he said.

"Within alternative investments, I would use this in the enhanced growth bucket as part of my emerging markets exposure.

"I kind of like that it's index-based. It's denominated in dollars, and you don't have the currency exposure because it's passive. It's only when you buy foreign securities, for instance in a mutual fund, that the currency exposure comes into play. You don't have that issue here."

Kunhardt said that he also likes the terms of the deal.

"It's a point-to-point issue. The formula tells you what to do with the return when you're done," he said.

"I like leverage if it works for me. It doesn't work against me here. They give me 20% leverage on the upside, no leverage on the downside. In addition to that, there is no cap.

"And I get a reasonable barrier at 25%. I say reasonable instead of good because the underlying indexes are very volatile. So while 25% looks attractive, it's not as generous as it seems."

Odd exposure

Michael Kalscheur, financial adviser with Castle Wealth Advisors, said that the underlying basket is too concentrated and too volatile for his style.

"It's a group of five emerging market countries, but a lot of that exposure is not that diversified. When one thinks of Far East countries, one has Japan in mind, and it's not there," Kalscheur said.

"It makes it very different from a broader index such as the MSCI EAFE index, which has a big allocation to Japan."

The MSCI EAFE index tracks the equity performance of developed market countries excluding Canada and the United States. Japan is the top country in this index with a 21% weighting.

"We have clients who have exposure to the MSCI EM fund, which is much broader than this. With this, you don't get Brazil, Russia, Mexico or India," he added.

The MSCI EM fund stands for the iShares MSCI Emerging Markets index fund, which trades under the NYSE Arca ticker "EEM" and tracks the performance of emerging markets worldwide.

Concentrated bet

"These notes are a very concentrated bet on emerging markets in a very specific area of the world," Kalscheur said.

"Here is my hesitation with this: If you're betting on a particular region of the world, if you think this region is going to outperform everything else, I would think that you would know which countries within that group are going to be the winners. It's such a concentrated bet. It's neither country-specific nor really diversified. Anyone with a particular knowledge of that region would probably want to take country bets, in my opinion.

"I personally don't see the benefit of spreading risk across these five indexes. I wouldn't have the expertise for such bet.

"A Far East basket should really include Japan. This one doesn't. And if we're talking about an emerging market portfolio, I don't really see the point of narrowing it down to those five countries."

Deal killer

Kalscheur added that he also is "uneasy" with the structure of the product.

"This is a structured note. You do have some leverage on the upside, but don't forget [that] you're giving up the dividends," he said.

The average dividend yield for the basket is 2.43% a year, or 8.5% during the period.

"The deal-killer for me is the barrier. This is not a buffer. The good thing is that it's a European-style barrier. But it's still a barrier. Once you cross that 25% threshold, you are fully exposed to the downside on a one-to-one basis," he added.

"You have a Far East countries basket that not only in 2008 went down more than 25%, but went down below 25% twice in the last five years. The basket dropped 35% in 2008, and in the summer of 2011, it went down 30%. This tells you that the chance of breaking that barrier is very real.

"I can't get excited about the product, the way it's put together. I can't figure out why this particular basket would be best. Maybe someone has a very focused goal with that part of the world. But I can't put my finger on it.

"We've looked at portfolios based on emerging markets or balanced portfolios based on EEM and EAFE. I'm not shy about investing in emerging markets. It's the way this one is built.

"I'd rather have a more diversified emerging markets portfolio or alternatively, some form of actively managed fund.

"Finally, this barrier is a deal-killer as far as I'm concerned. It's too volatile. I'd rather have a 10% buffer.

"The fee is another thing."

The estimated initial value of the notes on the pricing date is expected to be between $940 and $970 per $1,000 principal amount, according to the prospectus.

"That's between 3% and 6% to the investor. It's a bit rich and could have an impact on the return," he said.

HSBC Securities (USA) Inc. is the underwriter.

The notes will price Oct. 28 and settle Oct. 31.

The Cusip number is 40432XME8.

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