I just tried a CD that I know is HDCD (Van Halen - Diver Down) and it plays fine using the optical connection. The receiver is an Onkyo TX-SR502 and the DVD player is an Onkyo DV-SP301. Neither is HDCD compatable. The setup for the 702 is identical to the 502 (I had one and gave it to my sister to give me an excuse for upgrading to the 803 when it is available).
Settings - receiver:
The DVD player is connected to the receiver via Optical (Opt1 on the receiver) as well as with analog audio cables (required for Onkyo's RI feature).
The DVD input's digital input assignment is set to Opt1.
Settings - dvd player:
The Digital Audio Out section of the menu has these settings:
LPCM - PCM
Dolby Digital - Bitstream
DTS - Bitstream
MPEG - PCM
If I change the LPCM setting to OFF instead of PCM, then the DVD player will output Analog audio and the receiver's display will simply say 'Stereo'. Likewise, if you change the digital input assignment on the receiver to '---' (analog) the receiver will select the analog inputs - regardless of the LPCM setting of the player. With the DVD player LPCM setting set to PCM and the digital input assignment of the receiver set to Opt1, the digital signal is selected and the receiver's display will show 'pcm' and 'stereo'.
The thing to remember is that HDCD is regular PCM, but has been encoded in such a way that a player/receiver with an HDCD decoder will extract the extra information that has been matrixed in. If there is no HDCD decoder, then it will still play just fine. It is analogous to Dolby Surround Encoded tracks - if you don't have a ProLogic decoder, it will still play normally - the receiver just won't be extracting the surround channels that were matrixed into the 2 channel track.
Check you CD player settings.