HSBC's Mitts tied to S&P 500 offer full protection but cost is steep due to low interest rates

By Emma Trincal

New York, Dec. 24 - HSBC's upcoming principal-protected notes are aimed at very conservative investors who want full downside protection against market risk even if the upside exposure and the seven-year duration offer little appeal, advisers said. Low interest rates however have made these structures particularly difficult to price, they noted. As a result, issuers do not have much room to play with when putting together those products.

HSBC USA Inc. plans to price 0% Market Index Target-Term Securities due January 2021 linked to the S&P 500 index, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus the index return, subject to a minimum payout of par and a maximum payout of 160% to 170% of par. The exact cap will be set at pricing.

The final index level will be the average of the index's closing levels on the five trading days before the maturity date.

For Dean Zayed, chief executive of Brookstone Capital Management, the use of those products should be limited to clients who really need the protection because the terms offer limited benefits otherwise.

"If the goal was not to give full principal protection, I wouldn't buy the product," he said.

No gain scenario

"The cap is fairly good. But the seven-year time horizon is really the problem here," he said.

"It's a bit problematic if there is no coupon first of all. Most investors will have a difficult time investing in a product where there is no action between the time you purchase the notes and the time the notes mature. A lot can happen in seven years."

The long-dated product also created some upside risk: investors, in theory, could after seven years receive their principal but without any gains.

"Suppose you have a bull market for another six years and on the last year, the market turns into another 2008 crash. All of these gains are wiped out."

Alternatives

The structure could be recreated with more compelling terms, Zayed said.

"You could be long the S&P 500 and hedge that with long-term puts," he said.

"Or you could buy a bond portfolio and buy some calls. You could use an investment-grade corporate bond portfolio if you want to get more juice. It's true that you would be taking more credit risk, but at the same time, your portfolio would be more liquid and you would have more upside. It's all about risk reward.

"They bundle all these features in one product. It's convenient, it's easy. But I'm not so sure the terms are so competitive," he said.

Tough pricing

Jonathan Tiemann, president of Tiemann Investment Advisors, LLC, agreed but said that it was challenging for issuers to come up with attractive terms when pricing principal-protected notes.

"After compounding, your annualized cap is 6.95% to 7.90%," he said.

"You still have the credit exposure. You have the lack of liquidity.

"The terms are not very exciting but it's understandable given how hard it is to price those principal-protected notes in a low interest rates environment.

"Basically, you buy a seven-year zero. At the current seven-year Treasury rate, your price would be 84 cents on a dollar. So you would put 84 cents and get par back. That's the principal protection.

"With the 16 dollars left, you have to buy the at-the-money calls in order to obtain the one-to-one exposure on the upside. But you don't have enough to pay for it. So you could give less than 100% upside participation, like 70% for instance. If that's not an option, you need to get more money somewhere.

"That's where the cap comes into play. You have to sell options to get some premium. You're going to sell some calls at a strike price and that strike is your cap. The lower the strike, the more premium you get. It's by selling the upside that you're able to receive the premium to buy those calls. So now you can give investors the full upside, the one-to-one exposure, but of course, up to a point," he said.

The low interest rates environment was what caused those pricing challenges, he said, because issuers of principal-protected notes buy zero-coupon bonds to generate the protection. With low interest rates, the discount below par is not sufficient to invest in the calls.

"I wouldn't blame investors for not liking the deal. But if you want that structure, it's got to come out of somewhere," he said.

"You have to make the options very long and you have to put those caps, otherwise, you just can't price it.

"That's why you don't see a lot of those deals anymore."

Not for everyone

"These notes are for somebody who can forget about the money for seven years since it pays no coupon. In fact, they may even have to be subject to ordinary income taxes and report an interest every year even though there is no paid income," he said.

According to the prospectus, the notes may be subject to the "non-contingent bond method" tax treatment.

Under this treatment, noteholders are required to report original issue discount or interest income based on a "comparable yield" and a "projected payment schedule" every year even though no income has been received in cash, the prospectus said.

"These notes are not for everyone. You really have to want that downside protection and be ready to pay for it," he said.

The notes are expected to price in January and settle in February.

BofA Merrill Lynch is the underwriter.

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