HSBC's leveraged notes on S&P 500 offer long-term equity play, uncapped return

By Emma Trincal

New York, Nov. 9 - HSBC USA Inc.'s 0% trigger performance securities due Nov. 30, 2022 linked to the S&P 500 index should appeal to long-term investors looking for enhanced returns with no upside limitation, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par plus 200% to 215% of any gain, with the exact participation rate to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 50% and will be fully exposed to any losses if the index falls below the 50% trigger level.

"There is quite a lot of leverage for an uncapped product, but it's a lot longer than normal so it balances out," Hampson said.

"This is a long-term U.S. equity play. You have to be willing to hold the notes for 10 years. As a result, you have to be prepared to take on the credit risk, which you wouldn't have to that extent with a shorter tenor, "she said.

Future Value Consultants measures the risk associated with a product on a scale of zero to 10 by the riskmap, which is the sum of two risk components - market risk and credit risk.

The higher the riskmap, the higher the risk.

The notes have a higher riskmap of 4.25 versus 4.07 for similar products, which in this case represent all leveraged structures with or without a cap and with or without downside protection.

Issuer's risk

"Most of the risk comes from credit risk exposure," she said.

The market riskmap of 2.84 is "much lower" than the 3.10 score observed for similar products. It is also less than the 3.30 market riskmap recorded by all products.

On the other hand, the 1.40 credit riskmap exceeds largely the average for the same product type at 0.97 and is almost twice more than the 0.75 average score seen for all products.

"Compared to a direct investment in the index, you reduce the market risk with the 50% barrier and you have the increased gearing. But you have the credit risk, which is the price to pay for the enhanced return," she said.

Hampson said equity-based structured notes with a 10-year tenor in general are not that common. Yet the additional credit risk that comes with a longer duration is not unique to structured products.

"It's no different than investing in a 10 year bond. All face some credit risk," she noted.

Uncapped and leveraged

What made the notes slightly different from their peers in the same structure type was the combination of a low barrier on the downside with the high return potential. The return profile was somewhat unique also in that it offered investors a fair amount of leverage without capping the upside.

"This uncapped leveraged return is made possible by the fact that it is a longer product," she said.

"As long as you understand the idea of credit risk and that it's just a different category of risk, you stand the chance with this credit risk exposure to generate extra return.

"You still have the market risk because a barrier after all can be breached.

"There is no reason to presume that a 50% barrier over a 10 year is better than a 20% over two years. You need to run an analysis to determine that and I suspect that the risks are quite similar," she said.

Given the amount of risk, however, investors receive an attractive potential return, she noted, pointing to Future Value's return score, which is a measure on a scale of zero to 10 of the risk-adjusted return.

Return potential

The return score is calculated using five key market assumptions - neutral assumption, high and low growth environments, and high and low volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios, which in this case would be high-growth given the unlimited upside.

The notes have a 9.76 return score, which is "much better" than the average of the same product type at 7.30 and even better than the general average of 6.60, she said.

"When you have good leverage plus no cap, this is going to give you a good risk return profile," she said.

With the probability chart, Future Value Consultants estimates how the product is expected to perform under the five key assumptions. It assigns a probability of return outcome to each of the payoff buckets.

The chart is generated using a Monte Carlo simulation using various parameters, such as volatility, dividends and interest rates.

When using the neutral assumption, which is a risk free growth scenario, the notes show a 24% probability of losses versus a 76% chance of generating a positive return. It is in the 0% to 5% annualized return bucket that the highest chances of gains - with a 52% probability - are concentrated.

When running the probability tables on the high-growth scenario (based on which the return score is computed), the probabilities improve significantly, she said. The odds of scoring a positive return are now 92% while the probability of losses is down to 24%.

Attractive pricing

The price score reveals good pricing, she added. Future Value uses its price score to measure on a scale of zero to 10 the market value of the underlying components of the product. Calculated as a percentage of the initial investment, the score gives an estimate of the fees taken per annum.

The higher the score, the lower the fees and the greater value offered to the investor.

The notes show a 9.48 price score versus 7.35 for the average of leveraged notes and 7.06 for the average of all products.

The result is an above average overall score of 9.62, significantly more than the 7.33 average for similar products, she observed.

"The return score and the price score are both very high which of course is going to give you a top overall score.

"This high return score is mainly due to the uncapped return. But the two-times leverage amplifies this, with both features offering investors a good potential for the final return to be high."

"The price score suggests it's good value. By spending more on the options, the issuer has given the investor some very attractive terms," she said.

The issuer has announced a participation rate somewhere in a range between 200% and to 215%.

By convention, Future Value Consultants choose a value equal to 75% within the range, which is slightly favorable and nearer to the upper end.

"The only way the price score could be lower would be if they priced it at a lower level like 200% for instance. But even in that case, it would not make such a big difference.

"The fact is that we have a liquid underlying and a structure that is quite simple to price. You wouldn't expect too much fees with that type of product," she said.

The product would compete advantageously with an exchange-traded fund tied to the S&P 500 index, she said.

"It's a competitive alternative, but only if you're looking to invest for that time horizon. Once you have made your decision to hold the security for 10 years, it offers very appealing features when compared to an ETF. For instance you have the leverage and the barrier all in one. On the other hand, you're taking on credit risk and you're not collecting dividends. So if the S&P 500 has a 2% dividend yield, you need to get a 1% return to cancel out that disadvantage.

"These notes represent a long position in the benchmark, but one with a different risk return profile than a direct investment in the index," she said.

"It's a matter of deciding what types of risk you're willing to take."

HSBC Securities (USA) Inc. is the agent.

The notes will price on Nov. 27 and settle on Nov. 30.

The Cusip number is 40433T620.

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