HSBC to price trigger performance securities linked to Euro Stoxx 50; role of barrier eyed

By Emma Trincal

New York, Jan. 25 – HSBC USA Inc.’s 0% trigger performance securities due Feb. 7, 2019 linked to the Euro Stoxx 50 index offer uncapped leveraged return with a final barrier protection. Advisers had distinct views about the role and justification of the barrier in the structure.

If the index return is positive, the payout at maturity will be par of $10 plus 118% to 128% of the index return. The exact participation rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index return is zero or negative and the final level is greater than or equal to the trigger level, 75% of the initial level, the payout will be par.

If the final level is less than the trigger level, investors will be fully exposed to the decline in the index from its initial level.

Michael Kalscheur, financial adviser at Castle Wealth Advisors, who caters to risk-averse investors, said the terms of the notes were attractive on the upside, yet he was not interested in the notes due to the contingency of the downside protection.

He evaluated the issuer’s creditworthiness first.

“This note is a three-year. To us, three year is mid-term. You have the credit risk, but HSBC is a bank we would definitely do business with. It’s a solid credit.”

Client angst

His main concern was the current market.

“Share prices keep on trading down. Oil is down. Clients right now are uncomfortable,” he said.

“The market dropped precipitously in the first three weeks of the year. I don’t know what’s going to happen, but I know that I can reduce risk with a structured note. That’s really why we use structured notes in the first place.”

Unfortunately, this note would not allow him to mitigate risk as much as he would want.

“I can only reduce the risk with a buffer, not with a barrier,” he added.

“Don’t get me wrong. A barrier can protect my investment if it doesn’t breach. When it breaches, it becomes a cliff.

“With a buffer, I know what my risks are and how much I can cut the risk. There is always a protection.”

The duration of the notes was not long enough in his view.

“With a 75% barrier over three years, I’m not so comfortable,” he said.

“The chances of a 25% decline over a three-year period are much higher than over five or six years.”

5% risk is too much

Kalscheur has conducted a study for his firm that he uses with his clients based on the S&P 500’s returns since 1950. In a table, he compiled probabilities of specific loss amounts over various trailing periods.

“I don’t have my statistic table for the Euro Stoxx, but I know that for the S&P, a drop of the index of more than 25% over a three-year trailing period during the past 65 years has only happened 5% of the time,” he said.

The Euro Stoxx 50 would have a different probability, he noted, saying that the chances of losses may be greater, although he was not sure.

“But assuming it’s only 5% like the S&P, that seems reasonable doesn’t it? Well, that 5% probability makes me hesitate.”

He said that the probabilities of losing such amount were one aspect of the risk. The potential loss amount was also a significant aspect of the risk.

“It’s a 75% barrier. You know that if the barrier is hit, you are going to lose at least 25% of your capital. You can lose up to 100%.”

Buffer wanted

“If you have a buffer, it’s much easier to present the risk to a client. You know you’re going to do better anyway.

“But with a barrier, I find it difficult to look a client in the eye and tell him, ‘you’re giving up a 3% yield and you have a 5% chance of losing money.’

“For us, the buffer is much more in line with what we’re looking for, and that is helping clients to avoid the most disappointing outcome.

“Take a note with a 20% barrier versus one with a 15% buffer. The market drops 21%. You’ll either lose 21% or 6%.

“Your clients are going to either be happy or livid.

“It’s such a different outcome. That’s why we only use cliffs over longer maturities when the odds of losing are lower.”

Very bullish

Kalscheur said the notes were designed for more bullish investors. The absence of a cap will enable noteholders to outperform the benchmark, although the index needs to rise to a certain level before the leverage factor can offset the loss of dividends.

The Euro Stoxx 50 pays a 3% yield, which represents 9% of unpaid dividends over the term.

Assuming a leverage factor of 1.18, the index would have to be up 50% over the three-term period for the notes to outperform the total return of the index itself.

“It would take a lot. You really have to be bullish,” he said.

“People are anxious right now. They are staring at the market that has collapsed in the past three weeks. They don’t want to jump in with both feet. They want something a little bit more hedged, more conservative.”

Fees

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, had a different approach. Looking at the index chart, he felt comfortable with current valuations. Low entry prices made the need for the downside protection less pressing.

“First, the fee seems to be high. We’re fee-only. We would have to have a conversation to try to bring the fees down,” he said.

The fee is 2.5%, according to the prospectus.

“There is upside leverage, which is nice. It’s not a huge leverage, but the returns are uncapped, which we like,” he said.

“The barrier at first glance is nice, particularly at these levels.”

Euro exposure

He pointed to the Euro Stoxx 50 having underperformed the S&P 500 over the past few years as a potential value advantage.

The euro zone benchmark has dropped more than 20% over the past five years while the U.S. large-cap index has increased by 46%.

“The Euro Stoxx index had some disappointing returns. It doesn’t mean that it’s not a valuable investment. From a valuation perspective, Europe is much cheaper than the U.S.,” he said.

“It’s not a question of whether a U.S. portfolio should have exposure to Europe. It certainly should.

“It’s more a question of whether a structured note like this one is a valuable place to get that exposure.”

Foldes said that the answer to this question required comparing the notes with owning the index outright.

“You’re getting some leverage, you’re getting a barrier, which is nice because clearly we don’t know what the market is going to be three years from now,” he said.

Leverage versus dividends

“But you’re giving up the dividend yield,” he said.

“Your money is tied up for three years. Three years for us is on the longer side. We prefer not going beyond two years. Although HSBC is a large bank, you have to think of the credit risk.”

He concluded that the potential returns had to be stretched on the upside.

“The barrier is not so important. I’d rather see more leverage even if I have to reduce or even eliminate the barrier.”

Because of the weak leverage along with nearly 10% of missed returns, the odds of outperforming the index were too slim, he explained.

“The leverage is not sufficient to offset dividends. You would need a pretty high return to break even,” he said.

“Therefore, the leverage is not enough if you want to give investors a chance to make money.

“While having no cap is good, you want to increase the leverage in order to get paid for taking on credit risk, tying up your money for three years and giving up dividends.

“If it means losing some downside protection, I’m fine with that because you’re already investing in an underperforming asset class.

“Compared to the S&P, it’s a cheap index. You’re probably paying too much for that barrier.”

HSBC USA Inc. is the agent.

The notes (Cusip: 40434N606) will price Feb. 2 and settle Feb. 5.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.