HSBC’s $30.72 million notes with absolute return buffer on S&P 500 show deep bearish bias

By Emma Trincal

New York, Oct. 6 – HSBC USA Inc.’s $30.72 million of 0% capped notes with absolute return buffer due Sept. 27, 2024 linked to the S&P 500 index provide skittish investors a solid buffered protection and guaranteed outperformance on the downside, sources said. Gains on the upside are not suppressed as is the case with most bear notes but capped. However, the cap level may be deemed unattractive for those betting on a market recovery, sources noted.

The payout at maturity will be par of $10 plus any index gain, subject to a maximum payout of par plus 15%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes flat or falls by up to 27%, investors will receive par plus the absolute value of the index return. Otherwise, investors will be exposed to any losses beyond 27%.

Protection, hedge

“For people who are willing to potentially give up some upside and believe the market won’t go up more than 7.5% a year in the next two years, this is an excellent downside protection. It’s also a great way to outperform on the downside,” said Scott Cramer, president of Cramer & Rauchegger.

Investors may want to use the note as a hedge for a small portion of their portfolio in an attempt to get protection and absolute return on the downside while maintaining the potential to make 7.5% in a year on the upside, he noted.

Still the cap raised the risk of underperforming the S&P 500 index, he said.

“We may see further market decline in the short term, but two years is a long time. We have much more downside potential now than in two years. The market in two years will probably be positive,” he said.

“So, you have a potential opportunity cost, here.”

U.S. dollar headwind

Some of the short-term risks for the equity markets are associated with the U.S. dollar, which has surged this year even though it slightly dropped since the end of last month.

“I would keep an eye on the dollar. The impact of the Fed’s tightening is now visible in other parts of the world,” he said.

As the dollar is rising, other currencies like the British pound are plunging.

“Since many things are denominated in U.S. dollars, including of course oil, the appreciation of the dollar is a real headwind for other countries, which see the cost of goods going up, he added.

“Some countries are complaining that the Fed has raised interest rates too much. And since inflation is spreading a little bit everywhere, other central banks have been tightening as well.”

He said these “races” to tighten between central banks in order to reduce inflation is the reverse of the “races” to ease in the not-so-distant past when economies were struggling with recessions worldwide.

“This note is for a defensive investor. You are not going to get an excellent upside. But you are going to get an excellent downside. That’s the nature of structured products. You want exposure, go buy SPY. Investing is about tradeoffs,” he said.

Risk is on the upside

Steve Doucette, financial adviser at Proctor Financial, objected to the cap level.

“Somebody believes the market is going to be down in two years because that’s where you’re really going to outperform,” he said.

“You’re also giving up quite a bit if the market comes back up two years out and that’s very likely to be the case.

“Just look at how the S&P rebounded this week.”

The S&P 500 index gained nearly 5% from the open on Monday to Wednesday close.

“I wouldn’t be comfortable having a cap on this note when we’re already down more than 20%,” he added.

Maximizing the absolute return would imply another 27% drop from current levels.

“If you want to reach the top return in two years, you’re looking at a 47% decline. That’s a pretty big drop to bet on,” he said.

Treasuries

The risk was on the upside because the 7.5% cap was not “compelling” enough, he said.

“The one-year Treasury is now yielding 4.15%,” he said. “The marginal gain if compared with the 7.5% cap isn’t that great.”

The note may not even offer 7.5% since the return is based on the delta one return of the index.

“Long-term treasuries yield less but if we go into a recession and the Fed reduce interest rates – and I assume they would do just that – you may get some capital gains over your bond exposure.”

Treasuries if sold prior to maturity are not risk-free, however.

“If rates continue to rise, your long-term Treasury holding will be at risk, but it’s doubtful.”

Risk aversion

“This note is just a way to give clients who are equity-averse some exposure to the market. If you want to put some of your equity allocation into a hedge, it can be helpful,” he said.

But Doucette would not consider the notes with such a “low” cap, as he considers a market rebound within two years a likely scenario.

“Obviously, it’s an opportunity cost on the upside. We’re already down 20%. Another 27% drop in two years would be pretty ugly. I don’t see that.

“It seems like the note delivers excess protection. But if you’re bearish, that’s where you’re going,” he said.

If he had to restructure the product, Doucette would recalibrate the ranges or return on both sides of the trade.

“I’d reduce that buffer to see how much upside I could get. I would look at raising the cap first. If you start increasing the leverage it would take away your cap.

“But I wouldn’t do a 15% cap on a two-year note even with a great downside. I need to outperform on both directions,” Doucette said.

BofA Securities, Inc. is the agent.

The notes settled on Thursday.

The Cusip number is 40439N411.

The fee is 2%.

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