HSBC's contingent income step-up autocallables linked to S&P offer appealing but complex terms

By Emma Trincal

New York, Feb. 11 - HSBC USA Inc.'s contingent income autocallable step-up securities due Feb. 28, 2028 linked to the S&P 500 index offer above-market rates but are only suitable for investors who understand the nature of the risks and the complexity of the structure, sources said. In particular, investors are not guaranteed to get paid a coupon.

The notes will pay a contingent quarterly coupon if the index closes at or above the 70% coupon barrier level on the determination date for that quarter. The coupon will initially be 5.5% per year. It will step up to 6.5% on Feb. 28, 2018 and to 10% on Feb. 28, 2023, according to an FWP filing with the Securities and Exchange Commission.

After five years, the notes are callable at par plus the coupon if the index closes at or above the initial index level on any quarterly determination date.

If the notes are not called, the payout at maturity will be par plus the contingent quarterly payment if the index finishes at or above the 50% downside threshold level. Otherwise, investors will be fully exposed to the index decline.

Tony Romero, co-founder and managing partner of Suncoast Capital Group, a deposit brokerage firm, said that the risk/reward profile of the investment was relatively attractive.

"It looks like a decent deal for investors. I haven't seen that type of product before," Romero said.

"It's a complicated product, but it's worth looking into because in my opinion the chances of losing your principal are remote."

The chances for the client to get to the 10% annual coupon payment available after 10 years were also slim, he said.

"It's likely that you're going to get called after the fifth-year anniversary," he said.

"It's either you're going to be called or you're going to get the coupon. I wouldn't envision a scenario where the S&P 500 would be down 50% after 15 years. It's not unprecedented, but in my opinion it's unlikely. If it did happen, you could always buy a put as insurance, although this type of hedge would be expensive and the cost of the put would probably exceed your coupon."

Likely call

The most likely scenario, he added, would be for the investor to collect the coupon early on in the life of the product, when the notes are still call-protected.

"You'll definitely get your coupon at least for the first five years," he said.

However, investors should understand the reasons behind the attractive terms, in particular the 50% contingent protection at maturity and the coupon levels, which are above-market rates, he said.

"First, this is a note, not a CD. Therefore it's not FDIC insured and you are subject to HSBC credit risk. So you're assuming that HSBC will be around in 15 years. I personally believe that it will, but you still need to have the conversation with the investor and explain that they're not only exposed to market risk but also credit risk.

"Another consideration is that today the S&P is at all-time highs. Investors are betting that the four-year rally is going to continue. The current level of the S&P 500 may not wipe out your principal at maturity, but it could certainly erode some of your return as you are not going to get your coupon all the time."

Decent market risk

"Overall, they're definitely offering an incentive to make this investment with a 5.5% coupon for at least five years, which I believe you can get. The high coupon is justified by the additional risks you're taking, which are the potential for losing principal due to the index and the credit risk. These two risks dictate that you would be compensated more than with a traditional fixed-income security. And you are," he said.

Explaining to investors who are used to buying CDs or traditional fixed-income securities that their investment is not insured, that they may not earn the coupon at all times and that they may even lose principal based on the issuer's credit and the final level of the S&P 500 is probably challenging for an adviser or a broker, he said.

"The idea that they may not get their full investment back at maturity may turn a lot of people off, perhaps unnecessarily so," he said.

"If you put aside credit risk - I haven't looked at HSBC - I would be of the opinion that the chances of losing principal are very remote.

"If an investor can grasp this concept and understand what they are buying, I think the market risk is acceptable."

Contingency

Carl Kunhardt, wealth manager at Quest Capital Management, said that he would not even bother explaining the notes to his clients.

"I'm not going there with a 10-foot pole," Kunhardt said.

"The first item on my list before I even show something to a client is simplicity.

"I have to be able to explain the deal within two or three minutes. There's no way these notes are going to pass the three-minute test."

Kunhardt said that he sees more and more products structured around the idea of contingency.

"You either get a contingent barrier or a contingent coupon or both like in this note. It's not as great as the traditional buffer and coupon, but I can see why it's going in that direction," he said.

"They're doing it out of necessity to keep up the profit margins. The buffer is really the only risk that the issuer retains and they need to hedge it. In this economic climate, it's getting more and more difficult to hedge that risk profitably.

"There's got to be some profit margin built into a deal, otherwise why bother putting together a product? So they have to find innovative ways to still be able to structure and introduce some level of protection without compressing their profit margins to a point where they disappear."

While Kunhardt said that he understood the economics of a deal and the need for issuers to be "creative," he saw no reason why the new products would have to become "unnecessarily complicated" or more complicated than before.

Complexity trap

"I've seen the trend for a while with structured notes: they're getting more and more complex," he said.

"It's not true with every issuer. Credit Suisse notes for instance are pretty plain vanilla.

"HSBC in general has done a pretty good job at showing straightforward products, and maybe that was only the case up until this week."

This complexity trend was not a very positive development for the industry, he said.

"You have people like me who have been looking at fixed-income alternatives and have begun using structured notes more and more. As a result this market, which used to be a niche market a few years ago, is now getting wider and broader as more people continue to flock to structured products in search for decent yields and as alternatives to fixed-income," he said.

"We've seen where complexity led us a few years back. Look at the way some muni bond funds blew up in 2008 because they had auction-rate securities in it, which nobody understood anything about.

"I worry that Wall Street is beginning to think that good times are back again. And we're seeing crazy products again as a result.

"I'm a professional; I understand those products. But it took me less than 30 seconds to get turned off by this one.

"Wall Street is not going to increase their sales that way. People don't want to bother investing in complex securities like that."

The notes (Cusip: 40432XBD2) will price Feb. 22 and settle Feb. 28.

The agent is HSBC Securities (USA) Inc.

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