HSBC's leveraged buffered uncapped notes linked to low-volatility ETF offer defensive play

By Emma Trincal

New York, Jan. 2 - HSBC USA Inc.'s 0% leveraged buffered uncapped market participation securities due Jan. 28, 2019 linked to the PowerShares S&P 500 Low Volatility Portfolio exchange-traded fund may offer a defensive strategy for cautious investors expecting a market pullback sometime in the next five years, an adviser said.

However, some of the sectors heavily represented in the underlying index may not do well in a more bullish economy with rising interest rates, another noted.

If the ETF's return is greater than or equal to zero, the payout at maturity will be par plus at least 110% of the ETF's return. The exact upside participation rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the ETF's return is less than zero but greater than or equal to negative 20%, the payout will be par. Otherwise, investors will lose 1% for every 1% that the ETF declines beyond 20%.

Risk mitigation

"We know the S&P 500 has done phenomenally well over the last five years. It might be good to step in to a low-volatility index," said Steve Doucette, financial adviser at Proctor Financial.

"Low-volatility stocks do better in a down market than the traditional benchmark."

The S&P 500 Low Volatility index, which has been calculated since April 2011, measures the performance of the 100 least-volatile stocks in the S&P 500 index.

"This index will underperform in a bull market but not by a lot, and it reduces risk in a down market, which we may get after five years of a bull run," he said.

"Getting exposure to a low-volatility strategy in addition to a 20% buffer may not be bad. You want to be able to outperform on both sides. If you're OK with a steady return, it's a decent note. You have a buffer on the downside and some leverage with no cap on the upside. If the market goes down and back up, you still get some nice positive return."

The S&P 500 Low Volatility Portfolio ETF was launched on May 6, 2011. From inception until Tuesday, it has gained 33% versus 37.9% for the S&P 500 during the same period.

"We had a strong bull market since May 2011, and it did not underperform the S&P by a lot," Doucette said.

"It has really underperformed the benchmark in the last four months of 2013.

"Theoretically, when the market takes the big dips, low-volatility investing protects you from some of the risk. It looks like a great play coming up.

"Five years is extending a little bit longer than what we would like, but you have the potential to outperform on the upside with some downside protection.

"Besides, HSBC credit is among the top ones, so that's pretty good."

Top weightings

Greg Werlinich, president of Werlinich Asset Management, LLC, said that he does not have an opinion on the notes. But he pointed to the underlying index's top weightings, comparing their respective performance to that of the best-performing sectors of the S&P 500 last year.

"Utilities have shown the second-worst performance in the S&P 500 last year. And they are the top holding in this underlying index," he said.

Constituents are weighted relative to the inverse of their corresponding volatility, with the least-volatile stocks receiving the highest weights.

As of Dec. 26, the top two sector holdings of the index are utilities with a 23.65% weighting and consumer staples with a 20.82% weighting, according to the prospectus.

According to Standard & Poor's, the utilities sector of the S&P 500 index gained 13.21% in 2013. It was the second-worst performing sector after telecom services, which rose 11.47%.

"As rates rise, utilities are poor, and since rates have gone up over the past 12 months, they've suffered. One would have to question the direction of interest rates before investing in a note tied to an index that is heavily weighted in utilities. If rates continue to creep higher, something weighted 25% in utilities will do poorly," he said.

While the correlation between utilities and interest rates is negative, the correlation between rates and consumer staples is less obvious, he said.

"Interest rates would rise in a better economic environment, so staples should do OK even though not as well as discretionary. Staples tend to be more defensive, so in a growth environment, they suffer relatively to other sectors that have been booming last year such as biotech, technology, discretionary," he said.

Consumer discretionary was the top-performing sector in the S&P 500 index with a 43.08% gain in 2013, followed by health care with a 41.46% gain and industrials with a 40.68% gain, according to Standard & Poor's.

Information technology and consumer discretionary represent only 3.22% and 2.13%, respectively, according to the prospectus.

Financial stocks were the fourth top-performing sector with a 35.63% return. It was also the third largest component in the S&P Low Volatility index with a 15.23% weighting, according to the prospectus.

Defensive play

"Over the next five years, we are almost guaranteed to have a major correction," Werlinich said.

"We've had a five-year rally with virtually no serious correction at all. The law of averages suggests that we're going to have one.

"Some people think we're going to have a correction this year. I am not too sure because the economy is getting stronger, the Fed has signaled its changes, and we've got a budget accord, so presumably they will deal with the debt ceiling without too much trouble.

"But there will be a correction. As long as the market falls in a 10% to 20% range or less, then you're OK. But if it doesn't, you'll take some losses.

"If you feel a little defensive for the next five years, I can see that someone might want to look into that. But I'm not sure I would consider it myself.

"One positive aspect though is HSBC's credit. There's not much risk there."

The notes (Cusip: 40432XRS2) are expected to price Jan. 23 and settle Jan. 28.

HSBC Securities (USA) Inc. is the agent.

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