HSBC’s Mitts linked to S&P 500, Euro Stoxx 50, Nikkei cap upside but offer full protection

By Emma Trincal

New York, April 1 – HSBC USA Inc.’s 0% Market Index Target-Term Securities due May 2022 linked to the S&P 500 index with a 33.34% weight, the Euro Stoxx 50 index with a 33.33% weight and the Nikkei Stock Average index with a 33.33% weight offer one-to-one exposure to the equity basket. But returns are capped at 45% to 55%, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive at least par.

The cap will be set at pricing and represents an annualized return comprised between 5.45% and 6.45%.

Tough zeros

A market participant said that full protection on structured notes is so hard to price that deals have become rare.

During this year’s first quarter, principal-protected notes represented a third of 1% of total issuance volume, and last year’s comparable period showed the same low percentage, according to data compiled by Prospect News.

“They used to give you leverage on principal-protected notes, but now it’s totally out of the question,” this market participant said.

“This one gives you one-to-one with a cap because pricing would be too expensive. Rates are too low. There’s not much to work with.

“When you structure a principal-protected note, you’re long a zero-coupon [bond] and you’re long a call option on the basket.

“You want rates to be higher so the discount to face value on the zero gives you enough to spend on the call spread.

“The low strike is par. The upper strike is the cap. If you don’t have enough to spend on the spread, your cap gets lower.”

Term

Currently low interest rates contribute to reduce the appeal of principal-protected notes, he said. Often one way to raise the cap is to extend duration, but the term is already seven years, he said.

“The potential return is higher than a CD, but you’re exposed to credit risk,” he said.

“You have to be ready to take HSBC exposure for seven years. Personally, I think it’s scary. Not that HSBC is a bad credit in itself. But to hold any bank credit for seven years today is scary. Banks are subject to scandals, fines and a variety of risks.

“For a conservative investor comfortable with the credit risk, it could be a good structure. The potential return is better than a CD.

“But you’re locked in for seven years. It’s a long time to hold a note.”

No dividends

Jack Ablin, chief investment officer of BMO Private Bank, said investors should assess the cost of the protection in terms of unpaid dividends.

“You’re foregoing the dividends. The Euro Stoxx already has a yield of 3.5%. Let’s just assume the basket has a 2.5% dividend yield. That’s about 20% worth of return you’re giving up over the seven-year term,” Ablin said.

In addition, part of the protection may not be necessary.

“By bringing the three indices together, they’re bringing the volatility down. The indices may not move together. The chances of having a negative return over seven years are pretty low.”

Plain-vanilla paper

Ablin suggested that investors would be wise to compare the product to other instruments.

“You get capped to pay for that protection. If they cap it at 45%, that’s 5.5% a year,” he said.

“What about buying a portfolio of these three indexes and just holding it? Of course there is risk. But if you go back in time over seven-year periods, what’s the chance that you get a loss? I bet it’s very low.

“I’m not saying it’s a bad deal. But you have to understand what the cost of that protection represents. Do you think that it’s worth the loss of dividends and the cap on the upside?”

Investors should also compare the structured notes to a fixed-income instrument.

HSBC’s 4% bonds due March 2022 offer a 2.66% yield to maturity.

“Let’s just say you get 3% on the paper. Both are subject to the same credit risk. But the bond is a 3% guaranteed coupon while the notes do not guarantee any payment. You could get as much as 5.45% .You could also get zero.

“With a plain-vanilla bond, every six months, you get your coupon. That’s your control. That’s what you know you can get.

“You have to decide whether you’re comfortable with a return that’s tied to equity performance without any income or minimum return.”

The notes are expected to price and settle in April.

BofA Merrill Lynch is the underwriter.

© 2015 Prospect News.
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