HSBC’s limited loss notes tied to Hang Seng Enterprises to offer defensive bet on China

By Emma Trincal

New York, March 15 – HSBC USA Inc.’s zero-coupon 2% limited loss notes due March 28, 2022 linked to the Hang Seng China Enterprises index provide quasi full protection against market losses for investors seeking capped exposure to the Chinese benchmark.

The Hang Seng China Enterprises index consists mainly of H-shares, which are Hong Kong-listed shares of companies incorporated in mainland China.

If the index return is greater than zero, the payout at maturity will be par plus the lesser of the index return and the cap, which is expected to be at least 25% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index return is less than or equal to zero, investors will be exposed to the index’s decline, subject to a minimum payout of $980 per $1,000 principal amount of notes.

Volatile underlier

A market participant said that the 98% principal-protection was not worth limiting the potential for high returns offered by the underlying index over the next three years.

From May 2015 to February 2016, he noted, the Hang Seng China Enterprises index lost about 50%. But the bear market was followed by an 86.2% gain from that point up until the end of January 2018. Since then, the underlying price has dropped 17.5%.

“The index moves around a lot,” he said.

Bullish view

“But it seems to me that chances are it will be higher in three years than it is today since time always works in your favor.

“I don’t think all that downside protection is worth not getting any leverage on the way up. In addition to that, you’re capped at 25%.”

This market participant said his perspective was more bullish.

“Rather than tie my money for three years, I would buy the index directly and have the instantaneous liquidity.

“I get that the downside protection would be valuable for a less bullish or more risk-averse investor. But my personal risk profile is different.”

Asked how a 25% potential gain versus a 2% maximum loss did not constitute a satisfying risk-adjusted return, he said that time was an important factor to consider as well.

“Getting that type of payout profile over a short-term period with leverage would be great. That would be closer to an options trade. Options are short-lived and you’re getting a lot of leverage. But this is not the case here.

“Your risk is to end up underperforming the index over the course of three years. You could have wasted some precious time.”

As part of a plan

Lance Roberts, chief investment strategist with Clarity Financial, said that the notes could be appropriate for investors with defined return expectations.

“For somebody who just want exposure to China and who has a financial plan with the goal of making 8% a year, it makes sense. Why not capping yourself to 8.5% annually and be reasonably confident that your losses will be very small,” he said.

“The problem is that people want all the upside and not the downside. They tend to be greedy. That’s not the purpose of investing.

“If I want to earn six to eight percent a year, I can do that, limiting my downside risk to 2%.”

Protecting the downside is a key factor in generating consistent compounded gains, he added.

“You could get 10% a year on a first, second and third year. That would be an average of 10% a year. But if in the fourth year you lose 10%, what you did is take that 10% rate of return and reduce it to 5%.

“The takeaway here is that the compounding will only work if you don’t lose money.”

Conviction required

Investors in the notes would have to hold a bullish outlook on the asset class and not just buy the notes for the protection.

“You have to have a view and believe that China is going to do well over the course of the next three years,” he said.

“If not, you have to find another instrument.

“I am not sure I would personally make that bet.”

He cited the “slow economic growth” of China, which, in his view, is likely to be worse than what is officially reported by this country’s government.

He suggested that other securities may offer better alternatives.

“We’re 10 years into a bull market globally and the risk is that my capital may be reduced,” he said.

“While I understand that I can only lose 2% with this note, I also believe that over the next three years bonds and fixed-income instruments are going to outperform the stock market.”

HSBC Securities (USA) Inc. is the agent.

The notes are expected to price March 21.

The Cusip number is 40435UJQ8.

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