HSBC’s five-year market-linked contingent buffer notes on Dow to offer alternative to ETF

By Emma Trincal

New York, Sept. 15 – HSBC USA Inc.’s plans to price 0% market-linked securities with upside participation and contingent downside due Oct. 3, 2022 linked to the Dow Jones industrial average are designed for bullish investors who seek unlimited upside exposure to the market with some protection. As such the product can be used as an alternative to the exchange-traded fund tracking the U.S. equity benchmark, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par plus 110% to 120% of any index gain, with the exact participation rate to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 35% and will be fully exposed to any losses if the index falls by more than the contingent buffer.

Term and protection

“This type of leveraged note – five-year... not a lot of leverage... no cap and low European barrier – is very similar to what you can see in the U.K.,” said Hampson.

“If you compare it to the more common shorter notes in the U.S. market, what stands is the lower barrier. But it’s not surprising really. The maturity always has a big impact on the barrier level.”

“Over five years there’s more room for the underlying to move. While you may get an 80% barrier on a two-year you’re more likely to get a much lower barrier over five year.”

She warned of the danger of comparing barrier levels between products without taking into account the big picture.

“Advisers who are used to seeing 80% barrier on shorter maturities may think that this is more defensive. But as the maturity changes, you need to change your expectations as well,” she said.

“You can’t assess the risk just by saying: it’s a lower barrier... that must be lower risk. In a U.S. market where shorter-dated notes are quite common, you need to translate your expectations in line with the maturity.”

Growth

The notes were “clearly” bullish, she added.

“Some products have a lot of moving parts. This one does not. There’s no cap. It’s quite clear that it’s designed for investors looking to participate in the growth of the U.S. equity market,” she said.

“There’s a little bit of gearing which can compensate for the lack of dividends.

“You’ve got this barrier, which makes the difference between investing in the notes and buying the index fund directly.

“The protection provides a slightly more defensive alternative to the ETF.”

Stress tests

Future Value Consultants offers stress test reports on structured notes. For this product, Hampson used a hypothetical leverage factor of 1.5 times at the midpoint of the range. Each report is divided into 29 tables showing various outcomes, each of which varying with the product type. Probabilities are assigned for each outcome and in some cases average payouts are also included.

The firm runs a Monte-Carlo simulation from a “neutral” market assumption, which is the standard pricing scenario with a moderate growth assumption based on the risk-free rate and dividend yield.

Four other market scenarios are also used to run a simulation based on a particular outlook. Those are bull, bear, less volatile and more volatile assumptions.

Bullish

The notes only offer three possible outcomes.

“You either get more return than capital if the index is positive, or you get just your capital back if it’s negative but above the barrier level. Otherwise you get less than capital,” she explained.

One of the tests, the capital performance tests table, offers probabilities for those outcomes in all market scenarios.

Under the neutral assumption, investors have a 34% probability of getting their entire principal back when the index declines.

“That’s one of the ways this product will outperform the market even though it’s not the ideal scenario,” she said.

Another outcome – the breach of the barrier – will occur only 12% of the time in a neutral environment. This probability rises to 28% in the bear and drops to 3.5% in the bull.

Getting a positive return is expected to occur more than half of the time in the neutral scenario, 80% of the time in the bull scenario and 25% of the time in a down market.

“The bull market shows this product in its best possible light,” she said.

Payoff

The barrier offers contingent protection, which means that when breached, losses amount to at least 35% of the initial investment.

The same table displays the average payoff in each of the respective outcomes.

When a positive return is achieved, for instance, gains will average 25% in the neutral case.

In the less likely event of a negative outcome (12% of the time), investors will be hit by a 52% loss in average, according to the table.

The average return in the bull scenario rises to 42.5%. But should the barrier be breached, which is unlikely under this assumption as it only happens 3.5% of the time, losses would still remain high at 48%.

“In a bull market, you can potentially get a good return. Only in the case of a barrier breach will you suffer a significant amount of losses. That’s simply because once you hit the barrier you are no longer protected. Since the barrier level is already low, your losses will be heavy,” she said.

Backtesting

Future Value Consultants also runs back tested capital performance tests over the last five, 10 and 15 years.

As the current bull market is already more than eight years old, most results show very small probabilities of losses.

“If you look at the backtested results, over the past five, 10 and 15 years, the chances of getting a positive return are very high,” she said, pointing to probabilities of 94%, 73% and 69%, respectively.

“People need to be aware of the risks of making assumptions based on past performance results. But at the same time, investors like that kind of illustration. They want to know how the product has been performing in the past. It’s more tangible since it happened, while simulations are based on assumptions,” she said.

“Realistically over those past years of a bull market, this product has generated good returns.

“People who may consider this product would expect a similar pattern for the next five years.”

Whether their expectation turns out to be correct or not, the product still offers features that cannot be replicated in an ETF, she said.

“Compared to other notes this investment is quite straightforward. It’s not doing anything too clever, it’s not tied to an unusual underlying and it’s not giving you access to an exotic asset class,” she said.

“What it does best is to offer an alternative to an ETF. The barrier reduces the risk. That’s the selling point compared to a direct equity investment.”

HSBC Securities (USA) Inc. is the agent.

The notes will price on Sept. 28.

The Cusip number is 40435FFY8.

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