HSBC's uncapped notes linked to Dow offer good buffer but longer tenor, unleveraged exposure

By Emma Trincal

New York, May 23 - In its upcoming 0% buffered uncapped market participation securities due March 24, 2017 linked to the Dow Jones industrial average, HSBC USA Inc. will give investors up to a 22% buffer and a longer holding period of four years, which represents a type of trade-off issuers have recently pushed investors to make in a low-volatility environment as a way to offer decent downside protection on equity index-based deals, according to sources.

The payout at maturity will be par plus any index gain, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to the buffer amount of 17% to 22% and will be exposed to losses beyond the buffer, which will be set at pricing.

On the positive side, the notes offer an above-average buffer size and no cap on the upside, sources said. The less attractive terms were the longer tenor and the one-for-one participation on the upside with no leverage.

Four years

For Matt Medeiros, president and chief executive of the Institute for Wealth Management, not having a cap and getting a competitive buffer were worth holding the security longer as well as foregoing the leverage, especially for a note linked to a U.S. equity benchmark.

"My initial comment is I like the simplicity of the notes. There's not a lot of moving parts to monitor or track," he said.

"It reflects very well the view of somebody who has a positive opinion on the Dow. I think I'm very much in favor of not having the upside capped."

The four-year tenor was not necessarily a disadvantage when combined with the buffer, he noted.

"The 17% to 22% buffer is very attractive for this asset class. On a four-year term I'm comfortable with this level of protection, absolutely," he said.

"The fact that it's a four-year note should give the investor the confidence of being exposed to this asset class knowing that if we see short-term pullbacks, over the long haul, there's a generous buffer to give you peace of mind.

"When investors are looking at taking asset class positions, if they have too short a time horizon, a whole new level of complications and risk is introduced."

Given the strong equity market rally, the chances of a near-term correction have increased, he said, which may not be bad for the holder of a four-year note.

"The recent pullback is not something we expected, but at the same time it's not surprising given the recent run-up in the market," he said.

"The market is going to be very timid on any new surprise.

"When you look at the Dow, when you see a 3,300 points run in the past 52 weeks, to have a pullback like we've seen in the last few days is certainly within reason."

The Dow Jones industrial average has risen nearly 17% so far this year to 15,295. It fell on Wednesday, finishing the day off 80 points after Fed chairman Ben Bernanke's testimony before Congress. The benchmark has gained 22.5% over the past 12 months.

Nice buffer

Steve Doucette, financial adviser with Proctor Financial, said that it was difficult to assess the value of the buffer on a four-year term. He added that he was not convinced a good buffer was worth getting rid of the accelerated return on the upside based on the terms of the notes.

"It's a nice, plain-vanilla note," he said.

"When you look at what's happening in the market, consumer stocks, dividend stocks, which are the big constituents of the index, those stocks have been up and not all stocks have followed it.

"It's a pretty decent buffer. You never know what the market is going to be like, so it's nice to have that type of protection."

Doucette said that attractive buffers on shorter-dated notes are now less available for investors looking for exposure to U.S. equity markets.

"With this, you're getting a good buffer, but it's a four-year," he said.

"I guess that's the issuance trend right now. It's only with longer-dated products that you can get a decent amount of protection.

"They used to give you a pretty good cushion on a one-year. I don't know if you'd get much of a buffer on a one-year or two-year note tied to the Dow.

"Do I believe you need the buffer for four years? This market has been up for four years. That buffer might serve you well, so yes.

"After the market has been up, up, up, no correction, no adjustment, no down days, chances are that we'll have a correction at some point, maybe soon. But who knows when?"

Doucette, who said that he often solicits bids from issuers in order to redeem some of their structured notes early, noted that a longer tenor may not work in the best interest of the noteholder seeking liquidity if a market correction were to happen early on.

"The four-year duration is tricky. It's certainly hard to time anything. If you do have a correction, if the market drops by 20% in one year, from a valuation perspective it will be hard to put it back to the issuer because you wouldn't have realized the full potential of the optionality. The note would be underwater. You would already be behind the curve. You'd still have three years left. You might only be able to get 90 cents on the dollar, not 100%," he said.

Tough call

The notes are designed for bullish investors who want one-for-one upside exposure to the index with no maximum return, according to the prospectus. Having no cap is part of a trade-off as well, Doucette said, as investors have to be willing to give up any accelerated return.

"I'm not so sure that the 100% participation with no cap is necessarily the best way to go right now. I'm not saying that I expect a continued bull run, but we may still have a momentum market. It would be nice to have the leverage component," he said.

"I may find it more adequate to have a 10% to 15% buffer with a little bit of leverage like 1.1 or 1.2 times.

"Again, I'm not saying we're in perpetual bull market but four years is an entire cycle. If we end up after four years with a Dow at a lower level than what it is today, then yes, it would be nice to have this buffer. On the other hand, you could have a correction coming up soon and plenty of time for the market to recover after that, in which case, you run the risk of missing up on the upside.

"It's a tough one. On a relatively longer-dated product, it's not so easy to choose between leverage and protection."

HSBC Securities (USA) Inc. is the underwriter.

The notes will price May 28 and settle May 31.

The Cusip number is 40432XEM9.

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