HSBC's notes tied to S&P 500 offer 50% protection, leverage, but 10-year tenor is the price

By Emma Trincal

New York, Dec. 11 - HSBC USA Inc.'s 0% airbag performance securities due Dec. 30, 2022 linked to the S&P 500 index offer an attractive downside protection with uncapped leveraged upside, but in exchange, investors have to accept a long tenor. Sources agreed that extending durations allows issuers to introduce better terms. But not every buysider is willing to take on the additional risks such as interest rates and liquidity risks.

The payout at maturity will be par plus 165% to 180% of any index gain, with the exact participation rate to be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index falls by up to 50%, the payout will be par.

Otherwise, investors will lose 2% for every 1% decline beyond 50%.

Too long

"I'm not a big fan of long-term notes," said Tom Balcolm, founder of 1650 Wealth Management.

"Even though the leverage is nice, the downside buffer is nice; it's still a 10-year tenor.

"It's almost for a client who would buy this product and then go to sleep for 10 years.

"But 99.9% of our clients don't have a 10-year time horizon."

Balcolm pointed to interest rate risk as one of his main concerns.

"It's basically a 10-year zero with an option in it. If rates rise, guess what happens to the value of this investment? Most clients wouldn't be happy. You're pricing a zero coupon and you know that the value of this product will decline at maturity if interest rates are going up," he said.

Considering the risk, Balcolm said he did not find the upside sufficiently appealing.

Fee

"There's also this 5% upfront fee, which I call a yield-to-broker," he said.

"It's a great story to sell: look at the last 10 years. The market was flat. Here's something that gives you upside leverage, uncapped return and some downside protection.

"But you also have to take into account what you're not getting, in particular 10 years worth of dividends," he said.

The dividend yield on the S&P 500 is 2.07%.

"Not getting 2% for 10 years is a lot. It makes me wonder if the leverage is high enough. Looks like you should be getting more than just 1.8 times," he said.

Balcolm said that the "worse case scenario" would be the combination of an equity sell-off and a spike in interest rates.

"Two years from now, imagine the S&P 500 is down 20% and rates move up from 150 basis points to 300 basis points. The value of this note would be horrific if rates were to rise in a declining market," he said.

Deconstruction

Michael Iver, founder of iVerit Consultancy and former structurer, agreed that the long tenor was a risk. Even the buffer over that period of time may not be enough to bring total peace of mind to the investor.

"The 50% buffer is OK. I wouldn't say it's great because it's over 10 years and 10 years is a long time in stocks. At 50% decline over that length of time is not outside the realm of possibility," Iver said.

Investors should weigh the pros and cons of a deal in order to determine its value, he said.

"First you have to focus on what you forgo in order to earn that leverage," he said.

"You have to take into account what you would earn if you were to buy a Treasury or a corporate bond."

The 10-year U.S. Treasury yield is currently 1.63%.

Iver used the HSBC CDS spread of 80 basis points for five-year.

He also took into account the 2.07% annual yield investors in the notes are not receiving in dividends.

"So, the investor forgoes 4.5% per annum over 10 years give or take. When it gets compounded that's a lot of money," he said.

This money is used by the issuer to pay for the call options, which offer the upside leverage as well as the purchase of the at-the-money put options for the downside protection, he said.

No free lunch

Iver examined the risks.

"I have liquidity risk. My money is tied for 10 years," he said.

"There's a potential lack of competitive pricing to unwind.

"I'm forgoing the carry I could earn by buying the debt.

"And I'm paying up from us a 5% fee, which seems like a pretty hefty fee.

"But if you were a 10-year investor in structured notes buying six or seven deals over the next 10 years, you'd probably be paying a higher fee.

"So you're taking the upfront hit, but if you have a long-term view and want to hold a bond for 10 year, it's pretty rational," he said.

In exchange, investors are getting the 10-year leverage exposure and a downside protection of up to 50% for 10 years, he said.

Packaging the same investment in options would not be easy, he noted.

"Ten-years listed options on the S&P don't even exist," he said.

"When you look at that, you realize that the 5% upfront fee over 10 years may be reasonable.

"You can't really get those listed options anywhere and that means that the dealer is taking on significant hedging risk.

"They're taking on much more risk than any structured products with a 13-month maturity that they can hedge perfectly in the market. That comes with a cost. The dealer has no way of knowing how good the hedge will be. They get compensated for that. That's part of the upfront fee.

"Protection represents a substantial cost for the dealers. People need to appreciate that," he said.

HSBC Securities (USA) Inc. is the underwriter with UBS Financial Services Inc. as dealer.

The notes are expected to price on Dec. 26 and settle on Dec. 31.

The Cusip number is 40433T539.

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