HSBC and Solent Capital Group have teamed up to create a principal-protected note that exploits the discrepancy in value between five-year and 10-year credit indices.

The seven-year note, which is the first publicly offered product of its kind, aims to pay investors an internal rate of return of 9.25% by taking long positions in the 10-year mezzanine tranches of the CDX and iTraxx credit-default swap indices and short positions in the five-year indices.

Because the long positions are balanced against the short positions, investors aren't exposed to the risk of credit defaults û the notes are designed instead to play on the relative values of the two sets of credit indices, an approach that gives the product its name: Centris, short for credit-event neutral tranche index strategy.

"That's the key issue: the relative value trade between the five-year and the 10-year," says Jamie Spence, HSBC's head of structured product marketing for Asia Pacific. "The carry is significant, and there is potential for mark-to-market gains on the strategy if the curve flattens."

Solent will manage the investment strategy and HSBC will provide the principal protection, using constant proportion portfolio insurance. Initially driven out of Hong Kong by HSBC, the deal, which is reportedly in excess of $200 million, is being offered to investors throughout Asia, Europe and the Middle East.

The note offers a base coupon of 150 basis points over Libor, contingent on the performance of the strategy and payable every six months. Any excess carry generated by the strategy will be ploughed back into the structure to reach the target return of 9.25%, net of fees.

At the moment, the carry the strategy generates certainly looks attractive. With base assumptions of the 10-year CDX index paying 435bp, against 80bp on the five-year, investors get a 355bp carry. On iTraxx, the assumed carry works out at roughly 275bp. After paying 75bp for the principal protection and 50bp for management fees, and deducting the 150bp coupon, the strategy could still generate roughly 130bp in excess carry.

Needless to say, the returns are sensitive to spread movements. According to HSBC and Solent, a 10bp widening in years two and five would reduce the expected returns to 6.5%. By the same token, spread tightening creates an additional windfall. If the spreads move by the same amount in the opposite direction, the returns swell to 13.3%.

There is also sensitivity to movement of the credit curve. If the 10-year widens by 5bp in years two and five, while the five-year remains the same, returns drop to 7.1%. However, if the 10-year tightens instead, while the five-year stays the same, returns rise to 12.1%.

Centris also has an optional strategy of shorting the overall 10-year indices as well as individual names in the indices. It can also buy more protection on the five-year indices and adjust the leverage.

There is also a potential benefit derived from rolling the portfolio into the latest versions of the credit indices as they are updated every six months. The long/short strategy could allow the structure to generate some additional returns here.

In effect, rolling into the new indices adds a further six months of credit exposure. With a short position on the five-year indices this generates extra cost, while the long position on the 10-year indices gives a slight pick-up. The key point is that the pick-up at the 10-year part of the curve ought to outweigh the cost at the flatter five-year part of the curve.

Investors pay an upfront fee of 0.5% to HSBC when they buy the notes and 15% of the cash account above par at maturity to Solent, as well as the management and principal protection fees already mentioned.