HSBC’s contingent income autocall tied to Amgen include step ups for more coupon payments

By Emma Trincal

New York, Aug. 11 – HSBC USA Inc.’s contingent income autocallable step up securities due Aug. 14, 2020 linked to Amgen Inc. shares present an unusual feature. The call level steps up, which gives investors an opportunity to earn the coupon a little longer than if the call trigger was at par as it usually is, said Tim Mortimer, managing director at Future Value Consultants.

“It lowers the chances of a later call. And your chances of an early call are much less than with a typical autocallable product,” he said.

The notes will pay a contingent quarterly coupon at an annualized rate of at least 8.3% if the shares close at or above the 80% downside threshold on a determination date for that quarter, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if the stock closes at or above the call level on any of the first 11 determination dates. The call level starts at 105% of the initial share price on the first four determination dates, stepping up to 110% of the initial share price for the fifth through eighth determination dates and to 115% of the initial share price for the ninth through 11th determination dates.

The payout at maturity will be par unless the stock finishes below the 80% downside threshold, in which case investors will be fully exposed to any losses.

Range bound

“This call schedule that increases gives investors a greater chance of getting more payment.

“The feature has an impact on pricing. Pricing is cheaper. You get a higher coupon.

“If you happen to believe that the stock will trade reasonably range bound and stay above 80% that would be the kind of structure that would make sense.”

But as it is the case with any other structured notes, this product has its own limitations.

One of the downsides resides in the fact that the notes are likely to have a longer duration, modifying the risk-adjusted return of this type of product, which usually calls early and as a result, removes the risk exposure at redemption.

Longer

Investors can earn the coupon as long as the price on the quarterly observation is above 80% and the notes are not called even if the price is above par. For the first four quarters they can still get paid between 80% and less than 105%, then the window of income opportunity widens by 5% to less than 110% and finally during the last three determination dates, the range increases again by another 5 percentage points to less than 115%.

This mechanism expands the probabilities of the coupon being paid over a longer period of time than usual, he explained.

However as time elapses, the payout structure of the autocall, designed to be short-lived in nature, could in this case significantly underperform the underlying stock.

A different animal

“The fair value of an autocall, what’s always the optimal thing economically is to be called. This product is for someone who’d rather not be called and play the coupon longer,” he said.

“You could get called at the higher strike and the stock is already up even more, which means the notes can really underperform,” he said.

“The tradeoff you get with a normal autocall, which is to be paid and have no more risk, has completely changed. You hold the notes longer and the price difference between your return and the stock performance may be quite high.”

Under the right market environment, the notes however can deliver good returns for a decent period of time, he noted.

Less is best

Future Value Consultants produces stress test reports on structured notes. Each report contains 29 tables showing probabilities for a variety of outcomes, which differ depending on the product category.

Simulations are run for five different market scenarios: the neutral, on which pricing is based, as well as the following four: bull, bear, low volatile and less volatile.

The best scenario in terms of expected payoff is one in which volatility is subdued, according to the report.

In the less volatile scenario, the average payoff is 103.64%, slightly more than the bull assumption, which shows a 103.46% average.

“The range bound market is ultimately the best situation. The coupon is paid but you’re not necessarily called,” he said.

“The bull is not quite as good as that. Although it gets the coupon, it would be calling quite sooner.”

Scorecard

In order to check the probabilities of call occurrences at different call points as well as other outcomes such a capital loss, Mortimer pointed to the scorecard, which uses the base-case of the neutral assumption.

The chances of a call occurring on point 1 (first call date) are 31.55%.

“This probability would be much higher if the call trigger was at par, probably around 45%,” he said.

The same scorecard shows a probability of losing money at maturity of 19%. In such situation, the average loss would be 35%.

This scenario is the one in which the 80% barrier is breached. By definition, such outcome involves at least a 20% loss in principal since the barrier is European, in other words, observed at the end.

“The 35% average loss includes the 20% barrier breach. Since you’ve probably earned a few coupon payments during the three years, the capital loss is higher than 35%,” he said.

A look at the backtested scorecard shows that the highest likelihood of a call occurring on the first call point was observed in the past five years with a 45% probability. The same outcome had a lowest probability of occurring at about 38% for the last 10 years as well as for the last 15 years.

Stock higher

In conclusion Mortimer said the product was not necessarily a good fit for the usual autocall investor.

“A lot of products will call way before the third year. While this one still has a 31% chance of calling on the first call, it’s not designed for that,” he said.

Since investors are likely to hold the securities for a longer time than they would with a traditional autocall triggered at par, they should also be compensated for it, he said.

The 8.3% coupon reflects the higher premium. But investors are still in a position where they may compare their returns with a growth product and be disappointed.

“It’s a bit of a contradiction. Imagine the notes call at the end of the first quarter. The stock has to be at 105% for the call to occur. Yet, you’re only getting 2.075%. Eventually the risk of underperforming kind of catches up with you,” he said.

One possible solution would be to introduce a call protection, for instance during the first year.

“Of course, it would reduce the amount of coupon that you have,” he said.

But it may also reduce some of the risk of a barrier breach.

Risk

As the notes get close to maturity, investors have to worry about the downside protection.

Amgen, a biopharmaceutical stock, has an implied volatility of 20.18%, according to the report.

“An 80% barrier seems fair but we’ve seen deeper barriers than that, especially for volatile stocks like this one.”

At the end, having a sideways view on the stock will determine whether the choice is right or not.

“You can’t have the perfect product. It’s really a function of what the investor is after,” he said.

HSBC Securities (USA) Inc. is the agent, with Morgan Stanley Wealth Management handling distribution.

The notes will settle on Wednesday.

The Cusip number is 40435G683.

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