HSBC's leveraged buffered notes tied to S&P 500 Low Volatility target conservative investors

By Emma Trincal

New York, Feb. 7 - Despite a no-cap feature HSBC USA Inc.'s 0% buffered uncapped market participation securities due Feb. 27, 2018 linked to the PowerShares S&P 500 Low Volatility Portfolio exchange-traded fund, received a low return score from Future Value Consultants mainly because of the low volatility of the underlying, said Suzi Hampson, structured products analyst at the research firm. Given the reduced risk profile associated with the product, the issuer is likely to have targeted the more conservative investors, she added.

The payout at maturity will be par plus at least 1.1 times any gain in the fund, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the shares fall by up to 20% and will lose 1% for every 1% decline beyond 20%.

The notes fit into the "leveraged return" category in Future Value Consultants' methodology. The category enables the research firm to compare the product with products of the same structure type when assigning scores.

The key metrics of risk, returns and price are measured through various scores, which are established by Future Value Consultants. The research methodology generates reports designed to assess the quality of a product compared to the rest of the market.

Low volatility underlying

Hampson looked at the return score first, which is Future Value's measure of the risk-adjusted return for structured notes recently rated. The rating is calculated using five key market assumptions - neutral assumption, bull and bear markets, and high and low volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The return score for the notes is 6.29 versus 7.77 for the average of the same product type, according to Future Value Consultants' research report.

"It's low because it's based on the best performing scenario, which in this type of structure is going to be bullish. With an uncapped note, we expect the best assumption to be growth. You have a little bit of leverage here - 1.1 times the gains - but it's not much. So what really matters is the uncapped upside. And yet you don't end up with a high score because you compare this against other types of benchmarks and reference assets, which are much more volatile.

The underlying ETF tracks the S&P 500 Low Volatility index, which references the 100 least volatile stocks in the S&P 500 index.

"Although it's capped, the choice of a low volatility underlying reduces the potential growth. It's not as much growth as you would expect with that type of leveraged structure.

"Volatility is about movement. While we're picking the high growth assumption, which is supposed to yield the highest returns for an uncapped deal, this index is not giving you as much gains as average," she said.

Buffer

On the downside, the 20% buffer appeared attractive, she said, as investors get downside protection on the first 20% decline in the fund and then "lose one-to-one" beyond that level.

"Twenty percent looks like above average although you can't really say because it depends on the length and the underlying of a product. But it's fair to say that if you have a 10% buffer, the issuer can afford a higher participation rate, which could benefit the return score. We do see 10% with one or two-year products. It's hard to see what the larger buffers does here because you have so many other moving parts," she said.

Future Value Consultants assesses the risk of each product with its riskmap. This score measures the risk on a scale of zero to 10, with 10 being the highest level of risk possible. The riskmap is also the sum of two risk components: market risk and credit risk.

The market riskmap for the notes is 1.11 compared to 2.59 for the average of the same product type.

Low market risk

"It's much lower than most notes in that product category. That's essentially because of the level of buffer and the choice of the underlying.

"But the credit risk is actually higher due to the longer maturity. Five year is quite a long time. The average for those leveraged products is 18 months or two years."

The credit riskmap is 0.94 versus 0.65 for the average leveraged note.

Overall, however, the 2.05 riskmap is lower than the average of the same product type, which is 3.24, she noted.

"The issuer is probably targeting the pretty conservative type of investor," she said.

"By choosing this low volatility underlying, you're reducing the risk quite a bit. In addition, by picking a buffer, which at least by eye is bigger than average, the issuer is probably positioning the notes as a lower risk version of this type of product. It's designed to attract the more conservative type of investors among people who buy principal-at-risk structured notes," she said.

Price score

Another important rating established by the research firm is the price score, which measures for any given product the value to the investor on a scale of zero to 10. The score takes into account the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score is 6.19 compared to 7.71 for the average.

"This is not a good price score at all," she said.

"It's quite a lot less than the average of this product type. It's surprising somehow given the longer duration, which usually helps the price score since fees are calculated per annum.

"One explanation could be the underlying index, which is rarely used, making the pricing less competitive," she said.

Hampson noted that the 20% buffer was unlikely to have impacted the score in a negative way, or if it did, it would be difficult to assess how given the various moving parts. The leveraged return category is wide, including notes with or without downside protection, various tenors and different types of reference assets, she said.

"But we know why the 20% buffer is there. The issuer is probably marketing it to low-risk investors who want that type of downside protection. They're also using the less volatile stocks of the U.S. benchmark to reduce market risk. "That's the market they're going for," she said.

Low overall

Finally, the overall score measures Future Value Consultants' general opinion on the quality of a deal. The score is the average of the price score and the return score.

The notes received a 6.24 overall score. In comparison, the overall score of the leveraged return category is 7.74.

The price score and the return score, which are both below-average, contributed to lower the overall score, she said.

"We get a much lower riskmap than the average leveraged note, but the low return score tells us that even with this limited amount of risk, investors are not getting enough return.

"For investors whose priority is to limit risk, the notes may be attractive.

"But if risk is such a concern that you're willing to be compensated less than adequately, then maybe you should consider full principal protection because the return associated with these notes is still not quite up to average for this level of risk," she said.

HSBC Securities (USA) Inc. is the agent.

The notes will to price on Feb. 24 and settle on Feb. 27.

The Cusip number is 40432XSJ1.

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