HSBC’s capped return enhanced notes tied to SPDR S&P Bank ETF may have missed the bull party

By Emma Trincal

New York, June 22 – HSBC USA Inc.’s 0% return enhanced notes due July 11, 2018 linked to the SPDR S&P Bank exchange-traded fund offer a very compelling upside potential in a sector that has already enjoyed the lion’s share of the bull market of the past eight months. The sensitivity of the sector to political risk as well as its rich valuation indicates that the risk may be too high for cautious advisers.

If the fund return is positive, the payout at maturity will be par plus double the fund gain, subject to a maximum return of 20%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be fully exposed to any losses.

Rates

Steve Doucette, financial adviser at Proctor Financial, said his views on the notes and on the sector were mixed.

“If the Fed moves in the way they seem to move, if they push rates higher, this should benefit banks. If you think that’s enough to push the index higher, then I guess it’s a good note,” he said.

The underlying fund tracks the bank segment of the S&P Bank Select Industry index, in which regional banks represent a 78% weighting, according to State Street Corp., whose affiliates manage and distribute the ETF.

Regulation

Doucette added that some of the pro-growth reforms announced by president Donald Trump during his campaign should also have a positive impact on banks, especially on the smaller ones.

“If they cut taxes and regulations, it’s going to be very good news for regional banks. They have been hurt the most with Dodd Frank. They’ve been forced to do extra work, spend more money without necessarily having the extra margins,” he said.

Washington wildcard

The conditions are in place for a possible attractive bull play, he said. The potential 20% return after just one year seems attractive, he added. However such a bet is contingent upon the successful passing of new legislation.

“If all those reforms go through, the banks will do well. But it’s a big ‘if’. Over the next year, from my standpoint, it’s too hard to make a call on this asset class given all that uncertainty. Call it Congressional backlog, stalemate or dysfunction, we all know it’s possible that nothing gets done.”

Doucette said that he is in inclined to be optimistic.

“But that’s just a guess. Given the political risk in this sector, I’m not sure I would want to invest in the notes.”

Not broad enough

Doucette added two objections.

The first one was a reluctance to make sector bets in general.

“I tend to stay away from that kind of thing because you’re taking an industry-specific bet. We try to avoid that in general,” he said.

Crowded trade

Another concern was the market direction of the underlying index. The fund has gained 28% in the past year.

Most of the growth occurred during the post-election rally – the share price of the ETF jumped 30% in the month succeeding the November elections. The price peaked in the beginning of March, up 38% from the elections during a short four-month period, coined the “Trump rally” by traders. Since then, fund shares have shed nearly 10%.

For Doucette, the sector remains richly valued.

“I believe in mean reversion,” he said.

“The oil industry has been slaughtered this year. It’s in a bear market. I would be more inclined to be bullish when everyone is bearish. But bank stocks have had a big run. It’s like chasing the momentum. I’d rather be a contrarian.”

Correction risk

Brian Rettig, portfolio manager at the Institute for Wealth Management, reached similar conclusions based on the price momentum.

“I see a lot more risk on the downside than there is on the up,” he said, pointing to the lack of any barrier or buffer in the structure of the product.

“If you think it’s going to chop and consolidate more it may not be a bad play.

“But we’ve seen a big rally after November so if the reform expectations don’t match realities you could see a big move on the downside.”

Fed versus Mr. Market

Rettig said the sector is also very sensitive to interest rates moves, where uncertainty remains high due to different signals emanating from the Federal Reserve and the bond market.

Regional banks generate profits from lending. They pay deposits on the short end of the curve and earn interests on the long end with long-term loans, such as mortgages.

After the elections, the market expected the so-called “pro-growth” policies to reflate the economy and push up long-term interest rates, he explained.

“At first that’s what happened. But it did not last, he said.

“The Fed is raising short-term rates. However the Treasuries are not following suit. We’ve seen the 10-year, the 30-year trade back down to their pre-election levels.

The 10-year Treasury on elections day yielded 1.78%. By mid-December it hit 2.60% in the midst of the Trump rally fueled by reflation expectations. On Thursday the 10-year Treasury yield was 2.15%.

“The Treasury market is not following suit. Long-term bonds are not pricing in stronger growth and higher inflation.

“The Fed has baked into its forecast some expectations that have driven up the market for a while. But right now, the bond market is skeptical,” he said.

If he had to “reconstruct” the notes, Rettig would want a 20% buffer.

“I would probably have to extend the duration maybe to three or four years and perhaps decrease the leverage too.

“But it would seem like a better tradeoff to me.”

HSBC Securities (USA) Inc. is the agent. JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC will act as placement agents.

The notes are expected to price on Friday.

The Cusip number is 40435FAM9.

© 2015 Prospect News.
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