Potential higher rate offered by HSBC’s income plus notes on five stocks seen as hard to catch

By Emma Trincal

New York, Dec. 22 – HSBC USA Inc.’s income plus notes due Dec. 29, 2022 linked to a basket of stocks offer investors a fixed coupon, a contingent additional coupon and principal protection. But financial advisers were skeptical about the structure, saying the minimum coupon was too low in relation to the likelihood of getting the extra coupon.

The basket includes the common stocks of Coca-Cola Co., General Motors Co., Merck & Co., Inc., Philip Morris International Inc. and Verizon Communications Inc., according to an FWP filing with the Securities and Exchange Commission.

Interest is payable annually. The interest rate will be 1% plus (a) 5.25% if each basket stock closes at or above its initial share price on the valuation date for that year or (b) 0% otherwise.

The payout at maturity will be par plus the last coupon payment.

Innovative

Steven Foldes, vice chairman at Evensky & Katz/Foldes Financial Wealth Management, said he had not seen that type of product before.

“This is really a creative structure. I don’t particularly like it, but it’s creative nonetheless,” he said.

The fee is 4% or less, according to the prospectus. The set maximum amount of fees would include underwriting discounts and referral fees.

“If they collect the fees up front, I’m not particularly happy,” Foldes added.

“This maturity obviously makes it a long-dated note, which we don’t like.”

But Foldes’ main questioning related to the trade-off offered to investors: accept a very low guaranteed coupon in exchange for the potential of earning much more.

Not risk-free yield

“You are relegated to a 1% coupon. The rest depends on a basket of five stocks. If none of them is down, you get an additional 5.25%. This is difficult to achieve because all five have to be up every year. In addition, the amount of this potential extra income, 5.25%, is pretty modest,” he said.

“Even if you get the 6.25%, it may not be an attractive return in seven years.

“The 1% minimum is really a relatively modest boost. The seven-year Treasury yields 2%. You can’t even compare it with the Treasury since this note gives you exposure to credit risk. What you need to compare it with is a corporate bond with a similar credit quality. My guess is that you could get about 3% or 3.5% for the equivalent term.

“If the plain-vanilla bond yields between 3% and 3.5%, I’d rather own that and know what I’m going to get.”

The notes were designed for income investors, but Foldes said he does not look for “income products” for his clients.

“The best approach for income is financial planning. We don’t have income investors. We have investors who need cash-flow distribution from their portfolio on a monthly basis, and we provide it to them from the dividend, interest income and appreciation of the portfolio. We can have a lot of investment vehicles, not necessarily vehicles that provide income,” he said.

Yield alternatives

Jonathan Tiemann, founder of Tiemann Investment Advisors, also found the notes disappointing, arguing that it would be difficult to obtain the maximum yield of 6.25%.

“I don’t think my clients would like it,” he said.

“The problem is too much depends on the underlying. It’s a tough condition to meet if you want that extra 5%.

“If you are an income investor, you can get some yield without being too crazy. It’s not going to be very high yield, but still. You have preferreds. Some high yield-quality stocks pay high dividends themselves.

“What investors are trying to do with fixed income is to anchor their portfolios.

“Treasuries catch a bid when equity markets are in trouble. These notes would not increase in value in this scenario. They would be correlated to equities.”

The fact that the market is moving toward higher interest rates was not seen as the main problem, at least not in the short term.

“But over a horizon as long as seven years, you could get hit pretty hard if rates rise over that long period of time,” he said.

Anti-diversification

The notes fail to provide diversification away from stock returns, which is traditionally one of the advantages of fixed income, he noted.

“The real issue here is that if one of those five stocks is down, you’re not getting your 5.25%. You would do a lot better holding the portfolio if only one stock is down,” he said.

The lack of correlation between the five stocks in the basket represented an additional source of risk, he said.

“This deal, I guess, is the anti-diversification strategy,” he said.

“If you buy a diversified portfolio and if one of the items has an accident, the other stocks will mitigate the rest.

“This one is the opposite: one stock is down and it spoils the whole thing.”

HSBC Securities (USA) Inc. is the agent.

The notes will price Wednesday and settle Dec. 29.

The Cusip number is 40433UDU7.

© 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.