HSBC’s 14-month leveraged notes linked to DAX index have disappointing cap, buysiders say

By Emma Trincal

New York, Aug. 24 – HSBC USA Inc.’s 0% Accelerated Return Notes due October 2016 linked to the DAX index are an interesting single-country play for euro bulls, but the cap level is not enticing, sources said.

The payout at maturity will be par of $10 plus three times any index gain, subject to a cap of 13% to 17% that will be set at pricing. Investors will be exposed to any losses, according to an FWP filing with the Securities and Exchange Commission.

BofA Merrill Lynch is the agent.

Germany

“Basically, it’s the German Dow,” said Carl Kunhardt, wealth adviser at Quest Capital Management, who said he likes the underlying index.

The DAX index tracks the shares of the 30 largest and most liquid companies admitted to the Frankfurt Stock Exchange.

“It’s very short-term. Germany is the strongest economy in Europe,” Kunhardt added.

“If you’re going to have an international equity exposure, it’s going to be European-centric.

“People are not buying emerging markets at the moment. If you’re looking into developed markets, the first choice is Europe. And in Europe, Germany is the 800-pound gorilla ..., so Germany makes sense for any international portfolio.”

Flat only

But Kunhardt said the structure has its limitations primarily due to the cap.

“The three-times leverage is the shiny thing, but it doesn’t really help,” he said.

“A 17% cap on 14 months looks relatively generous. But if the market is up 5.67%, you’ve already hit the cap. On an annualized basis, that’s less than 5% and here you are ... capped out.

“The leverage is going to help you only if the market is pretty pedestrian.

“The three-times leverage does nothing for you. If the market is up, you’re going to miss on some of the upside. If it’s down, it’s useless. Here are the two book-ends, the two polar opposites you’re dealing with.

“This leverage is useful to have only if the market is flat. Meanwhile you’re paying for it. The price is baked in to the cost of the notes.”

The fee is 2%, according to the prospectus.

Opportunity cost

Another issue, he noted, is current equity valuations as global markets are entering a correction phase.

“Whether the correction happens all of a sudden or gradually, valuations are coming down to where they’re supposed to be. The best time to buy is when prices are lower. If you have the stomach to buy low and sell high, this note might be a good strategy ... except that the cap is going to work against you. When the market goes down as it is right now, returns during the rebound are supposed to be pretty significant,” he said.

On Friday, the Dow Jones industrial average officially entered correction territory. On Monday, the Shanghai stock market closed down 8.5%. Markets in Europe and the United States were under selling pressure along with emerging markets.

“The absence of a downside protection is not so much of a concern here because you’re already buying at a low,” he said.

“What I’m more concerned about is to miss some of potential gains as rallies always follow corrections.”

Non-starter

Steven Foldes, vice chairman at Evensky & Katz/Foldes Financial Wealth Management, considers both the lack of protection and the existence of a cap to be problematic.

“We don’t love this note,” he said.

“We don’t have a problem with HSBC, and 14 months is an acceptable term period. The fee is high, but it’s a brokerage deal, so we would renegotiate it as an RIA.

“What’s a killer for us is that in addition to not having any downside protection, there’s also this cap. It’s a non-starter for us.”

The current market tumble could offer attractive future returns, he said.

The Dax index was down nearly 5% on Monday. The S&P 500 index entered correction mode for the first time since 2011, down nearly 4%.

“To have a note with such a low cap makes no sense. You’re betting on a very modest recovery. We would be hurting the client by virtue of giving that type of return given where the current pricing environment is,” he said.

“If things turn around, you lose. If things get really bad, you lose.

“You can’t be bullish because the cap is too low. You can’t be bearish because there is no downside protection. It’s only going to help if the return is very, very modest. It’s a very narrow band you have to fall into.

“We would need to see a higher cap or a lot of downside protection. You have neither. It doesn’t make a lot of sense to us.”

The notes will price in August and settle in September.

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