HSBC’s $39.75 million 10% STEP Income tied to Gilead offer bullish bet on stock, no barrier

By Emma Trincal

New York, Nov. 19 – HSBC USA Inc.’s $39.75 million of 10% STEP Income Securities due Nov. 27, 2015 tied to Gilead Sciences, Inc. stock topped the list of deals last week. Sources said it was a popular structure as it offered a fixed coupon plus a potential bonus over a short period of time. However, given the absence of downside protection, the notes were aimed only at bullish investors, they noted.

If the stock finishes at or above the step level of $111.87, 110% of the initial price, the payout at maturity will be par plus 5.42%, according to a 424B2 filing with the Securities and Exchange Commission.

If the stock finishes at or above the initial share price but below the step level, the payout will be par. Investors will lose 1% for every 1% decline in the stock.

The fixed-interest was paid quarterly.

Reverse convertible type

“We call these transactions reverse convertibles. It has a fixed coupon, unlimited downside. Usually though, it goes with an American barrier, which you don’t have here. Instead you have the step payment on top of the coupon if you reach a certain level. So that would be the main difference. But basically it’s the same concept: you give up your upside in return for a bigger fixed coupon,” said an industry source.

“You get the 10% coupon no matter what and you may get an additional 5.50% bonus if the stock is higher than 110%. Your maximum return is 15.50%. If the stock finishes up positive anywhere between 100 and 115.50% you will outperform the long position.”

Gilead Sciences is a volatile stock, he said. Its implied volatility is close to 40% versus 12% for the S&P 500 index.

“You’re selling volatility and take the premium to get the 10% coupon. You’re selling an at-the-money put on the downside, which gives you the full exposure to risk. And they’re getting the extra 5% with some kind of call spread.

This note is very bullish in the sense that investors don’t feel the need to pay for a protection.”

With the more traditional reverse convertibles, investors benefit from a barrier on the downside, he said.

In return, they are usually not entitled to receive an extra coupon and the fixed rate may be slightly lower.

“If you had an 85% or 90% barrier on this, you might be able to still get a decent coupon. It might not hurt the upside too much. Some people might prefer that, others won’t. If I was an investor, I would probably want to get a little bit of protection. I don’t think it would be that expensive, by that I mean, I don’t think I’d have to give up a lot of the coupon. But it’s just my personal preference,” he said.

Research factor

A market participant said that Merrill Lynch, which distributed the notes, had the advantage of its research.

The Step-Income Securities are registered trademarks of Bank of America, and the agent sells them on a regular basis.

“It’s a Merrill Lynch-type of transaction – very short-term, and designed for investors who have a bullish view on the stock,” this market participant said.

“If you showed it to retail, it wouldn’t sell that quickly because in the absence of any protection, you need to have an analyst that provides the research on the stock. Not every firm has that capacity. When you’re taking that type of risk, you probably need conviction; therefore, the role of research backing your view is important.”

Still, investors were exposed to non-negligible risk given the terms and the volatility of the underlying security even if the coupon could always be used as a protective cushion.

“This is the biotech industry. You may have a 10% coupon, but if the stock plummets 20%, you recover 10% but you still lose 10%,” he said.

Another possible explanation for the strong bid was the entry point, he added.

The notes priced on Nov. 14 with the stock closing price at 101.70.

“The timing is quite good on this trade,” he said.

“If you look at the stock, it reached its high at the end of October. Since then it has come off. When they priced it last week, it was at its lowest level since the dislocation we saw back in mid-October. Investors in the notes have locked in at a pretty decent level,” he said.

“Overall, I think that Merrill’s ability to incorporate its research in their products along with the time of pricing and the volatility of that name are some of the reasons why the trade was popular.

If the analyst’s view is bullish, it’s easier to make that transaction happen because you have someone who follows the stock, who predicts where it’s going to trade and who can define a range.

“The deal is not for the super bullish investor because you still have a cap of 15.5%.

“But it’s an interesting play on a reverse convertible theme if you have the stomach for it because the trade can go significantly against you.”

The notes priced on Nov. 14.

The Cusip is 40434D137.

Merrill Lynch & Co. was the underwriter.

The fee was 1.75%.

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