HSBC’s leveraged notes tied to three insurance stocks designed for mildly bullish sector play

By Emma Trincal

New York, June 16 – HSBC USA Inc.’s 0% Accelerated Return Notes due June 2016 linked to a basket of three insurance sector stocks intrigued advisers for the concentrated nature of the underlying basket and the high leverage factor with no downside protection.

The structure is designed for investors seeking an exposure to the three insurance stocks who are betting on limited returns and no downside risk, they said.

The equally weighted basket includes Hartford Financial Services Group, MetLife, Inc. and Prudential Financial Inc., according to an FWP filing with the Securities and Exchange Commission.

If the basket return is positive, the payout at maturity will be par of $10 plus triple the basket return, subject to a maximum return that is expected to be 29% to 33% and will be set at pricing. If the basket return is negative, investors will have one-to-one exposure to the decline.

BofA Merrill Lynch is the agent.

Puzzling basket

Carl Kunhardt, wealth adviser at Quest Capital Management, said he is “puzzled” by the underlying basket.

“I’m not sure I understand why you would pick those three stocks,” he said.

“Obviously the structure is designed to offer a concentrated exposure to the insurance sector, but why? The correlation between insurance and financials in general is almost perfect. With such high correlation, your basket is going to move exactly like a financial ETF. So why would you pick this very narrowly focused investment on three insurance stocks? These are not bad stocks, but if you want a pure sector play, you cannot ignore the mutuals.”

He was referring to mutual insurance companies, which are entirely owned by policyholders. Examples in the United States include Liberty Mutual Group Inc. and Guardian Life Insurance Co. of America.

“Did they choose those stocks based on their performance? Their dividends? Their line of business? It’s very unclear to me. It may be because they’re trying to push the three stocks, and that’s a good way to do it. But I’m not sure these three companies are necessarily a good benchmark for the sector,” he said.

“The structure in itself is not bad. But it really depends on what your expectations on these three stocks are.

“MetLife, Prudential are two pretty high-moving stocks. Hartford has been somehow moving sideways.

“I guess if you are bullish but don’t expect outstanding returns, the three-times leverage can come in handy.

“But since I don’t understand why and how they picked those three stocks, I can’t really say I like the deal.”

Not a proxy

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said the basket is not designed to be a proxy for the industry.

“If you’re going to go into the insurance arena, these are three of the big boys. But from the standpoint of these three names being representative of the industry, I would say no,” he said.

He cited the top 10 holdings of the Fidelity Select Insurance Portfolio, which ranks MetLife second but Prudential only ninth and does not mention of Harford. The top holding in this mutual fund is American International Group, Inc. The other companies among the top 10 constituents are Travelers Cos. Inc., Ace Ltd., Marsh & McLennan Cos. Inc., Chubb Corp., Allstate Corp., Aflac Inc. and Principal Financial Group Inc.

“This basket just happens to be three individual single stocks. The issuer is not trying to proxy the industry. They’re just giving you some exposure to these three individual names,” he said.

Single stock risk

But Kalscheur said that the underlying basket is problematic.

“I’m not excited by this basket,” he said.

“While it’s easy to explain it to a client, I’m not a big fan of just having three stocks. It’s only three names. It’s not an index. It’s not even an industry. If one of these stocks blows up, it’s significantly going to impact your portfolio,” he said.

Kalscheur said he has looked at baskets of stocks before but never with fewer than 10 or 15 stocks.

“I would think 15 is a minimum to diversify and get away from individual stock risk,” he said.

In general though, he said he is “staying away” from stock-picking.

“Something like this is not going to come across my desk for consideration simply because we don’t even look at single stocks or small baskets,” he said.

“It’s just not part of the business we do. I can’t take the time to research these names, make a recommendation and then put a structured note on top of that. It’s way too time-consuming.”

Leverage, creditworthiness

The structure of the product is not seen by these financial advisers as a good fit for their clients.

“It’s a pure leverage play on three widely traded insurance stocks,” Kunhardt said.

“You’re only looking at the upside since you’re trading the downside protection for the high leverage. When you do a leverage play of that kind, you don’t really care about the downside risk. To me, it’s a speculative play.”

Kalscheur noted one very positive aspect of the structure: the creditworthiness of the issuer.

“Having HSBC as the issuer is encouraging. We have no qualms with them. They’re rock solid,” he said.

The five-year credit default swap spreads for HSBC are 42 basis points, according to Markit, compared with 64 bps for Bank of America, 68 bps for Goldman Sachs and 63 bps for Morgan Stanley.

Losing two out of three

But Kalscheur said that he is “not comfortable” with the structure itself.

“At first glance, the structure is not too bad for a two-year,” he said.

“But it violates one of my key tenets, which is that you want to win two out of three times.

“This deal has some good leverage. If the stock is up a little bit, you do very, very well. The notes are three-to-one leverage, and you’re capped at 30%. If the basket is up only 5% a year, you’re hitting your cap. With that type of leverage, you’ll get to that cap pretty quickly. If they had offered a two-times leverage with a 50% cap, I could have grabbed a little bit more on the upside.”

Both bulls and bears could not be “happy” with the notes, he said

“If you’re a bull, you buy the stock so you’re not capped. If you’re a bear, you don’t buy those notes because there is no downside protection. In those two scenarios – really bullish and bearish – you lose. It’s two out of three where you lose,” he said.

“It’s not a terrible cap, but with the leverage inherently in it, you’ll hit that cap awfully fast.

“It would be a different story if you had had a 10% buffer over a longer period of time, but you have no downside protection on a basket of three stocks for a two-year. It’s not terribly attractive to me.

“The shorter the time period, the bigger buffer I need for my clients to protect the downside. This is just too short for a deal with no protection.”

Beta, cost

The volatility of each basket component enhances the market risk, which he analyzed in terms of beta. A beta above one indicates a greater volatility than the market, while a beta below one shows a less volatile stock.

Hartford, MetLife and Prudential have a beta of 2.03, 2.18 and 1.79, respectively, he noted. The average for the basket is 2.

“I can’t take that much risk. I’m looking at structured notes to hedge my risks. That’s why I buy these things,” he said.

“At least they’re being honest and upfront in the way they label the product. It’s an accelerated return note. It’s a performance enhancer. That’s what it’s designed to do.”

Another concern, he said, is valuation, which he measured using Morningstar ratings. According to the investment research provider, Hartford and Prudential are “fairly valued” while MetLife is “overvalued.”

“I can’t get really excited about these stocks,” he said.

“We’re hitting all-time highs on the S&P. Right now, people are concerned about the downside risk, not so much about three to one.”

Finally, Kalscheur looked at the cost of the deal. The fee is 2%, according to the prospectus.

“A 2% fee for a five-year note is not bad. But a 2% on a two-year is just very expensive,” he said.

The notes will price and settle in June.

© 2015 Prospect News.
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