HSBC’s digital dual directional notes linked to S&P 500 seen as ‘intriguing’ and promising

By Emma Trincal

New York, Oct. 20 – HSBC USA Inc.’s 0% uncapped digital dual directional notes due Oct. 30, 2020 linked to the S&P 500 index caught the attention of buysiders due to its hybrid structure that combines uncapped upside with the characteristics of a dual directional payout delivered in a digital format.

If the index finishes at or above the 80% barrier level, the payout at maturity will be par plus the minimum upside return of 22% to 27%, and investors will receive 1% for every 1% gain above the minimum upside return. If the index finishes below the 80% barrier level, investors will be fully exposed to the decline.

The exact minimum upside return will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Digital wanted

“This is certainly an intriguing and creative note that can work for both bulls and bears,” said Dean Zayed, chief executive of Brookstone Capital Management.

“I have seen tremendous interest in the dual directional structure given the August correction and the noise around the market potentially correcting further. Investors who need growth but are nervous and want to limit risk may be attracted to this product.

“Given the market’s levels and using valuation metrics like the Schiller P/E, a dual directional note makes a lot of sense at this time.”

Unique

Zayed explained that the structure of the product differs from the classic version of a so-called dual directional or absolute return product.

“The digital payout on the downside is unique,” he said.

“The S&P can be down 1% in five years and the investor will earn 22 to 27 times that depending on where they set the minimum return.

“Typically, the standard dual directional note is a one-to-one absolute return on the downside, not a jump. In that way, the note is very attractive.”

He offered an example: In a traditional dual directional note with an 80% barrier on the downside, a 10% decline in the index would result in a 10% gain for the investor. With this product, investors would earn the minimum return of 22%, which is higher than what they could earn on a one-to-one basis.

“This note is likely to appeal to nervous investors who are conservative or have a moderate tolerance for risk but who still need growth,” he said.

Absolute value

Steven Foldes, vice chairman of Evensky & Katz/Foldes Financial Wealth Management, said the structure is “very interesting,” although he would consider looking into improving some of the terms.

“It’s very interesting because of the fact that you can get 25% if the index is negative as long as you don’t breach the barrier,” he said.

He used a hypothetical 25% minimum upside return.

Noticing the difference between a traditional barrier, for instance with a leverage return product, and the barrier associated with this note, he said that “if the return is negative, you get not only a significant protection for the first 20% but that protection translates into a gain.”

The upside also offers attractive features.

“Even if the index gain is limited, even if it’s up by only 1%, you get the 25% return.

“And beyond that 25% minimum, you’re not capped, so you get the full benefit of the S&P, which is nice.”

He said that a wide range of investors may be interested in this note with some exceptions.

“Of course you don’t want to be very bearish because if you breach the 20% barrier, you have an issue,” he said.

Fee, protection

The “one thing that’s unattractive,” he said, is the fee, which the prospectus said may be as high as 3.75%.

“That’s something we would have to talk about with the bank,” he said.

He also pointed to some of the pros and cons of the downside protection feature.

“The protection is a barrier, not a buffer, so the protection is not absolute. But the nice thing is that you’re getting this 25% gain if you’re above the barrier level, which is a nice result. It’s 25% even if the S&P is down 19%,” he said, adding that a normal barrier would only give an investor his principal back.

“There are a lot of real positives about the note the way it’s set up. I probably would like to explore this deal further with HSBC.”

His main goal would be to secure more downside protection.

Let’s talk

“If I had to remodel the notes to make it more attractive to us, I would love to know how we could obtain either a deeper barrier, 30% for instance instead of 20%, or a 20% buffer and see how it would impact the terms,” he said.

“I would not be willing to take a cap because you’re giving up too much upside potential. Over a five-year period, you’re talking 10%, 15% a year, which is not impossible. I like the fact that this note is not capped.”

He explained the type of trade-off he would be able to accept.

“What I would be willing to negotiate is the amount of absolute return I get providing that I’m able to get either a lower barrier or a buffer,” he said.

“I would be willing to trade the minimum digital return for greater protection. I think it would make the note more attractive, more compelling from a client’s perspective. If the market is down, you get something. If the market is down a lot, you get a significant protection. You win on the upside. You win on the downside as you get a lot of protection with the absolute return. What’s wrong with that?”

Two things, he said, and one of these would have to be negotiated.

“You do give up the dividend, which compounds over five years – that’s the loss here. Your protection comes with a cost,” he said.

“But for the 3.75% clearly that’s not something we would be willing to pay.

“Overall, I find this product very interesting. It just needs some adjustments.”

HSBC Securities (USA) Inc. is the underwriter.

The notes are expected to price Oct. 27 and settle Oct. 30.

The Cusip number is 40433UAW6.

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