HSBC's leveraged notes tied to Euro Stoxx 50 offer high return score, but pricing disappoints

By Emma Trincal

New York, April 25 - HSBC USA Inc.'s 0% leveraged tracker notes due April 2021 linked to the Euro Stoxx 50 index maximize the chance of outperforming the index in a bull market, but the price score of the notes suggests that value could have been improved, especially by introducing downside protection, said Tim Mortimer, managing director of Future Value Consultants.

If the index return is greater than zero, the payout at maturity will be par plus at least 255% of the index return. The exact upside participation rate will be set at pricing. Investors will be fully exposed to any decline in the index, according to an FWP filing with the Securities and Exchange Commission.

"This note is for investors who have a long-term bullish view on the euro zone equity market," he said.

"This is for investors who want to be long equity but not on the S&P because U.S. stocks have already performed so well."

The notes do not limit the upside, but they don't offer any downside protection either. The structure is centered on the enhancement of the return - uncapped and leveraged upside - which is obtained by lengthening the duration of the product, Mortimer explained.

Riding the bull

Removing the cap is a driving trend right now, according to market participants.

"The S&P has been so strong last year, along with most equity indexes, that investors are growing more and more resistant to the notion of limiting the upside," Mortimer said.

"Structured products investors tend to want a bit of everything.

"They want downside protection. But then they have to tolerate a cap. When capping the upside is not such a popular strategy, they have to accept another type of compromise.

"People have seen a very bullish market, and they assume it will continue to be very bullish. It's a classic investor's reaction. I'm not sure it's very logical. Instead it may be time to aim for modest market growth, in which case combining a cap with some downside protection would make more sense. But investors' behavior tends to lag the market."

The longer term of this product is designed to enable the issuer to remove the upside cap, he added.

"When you offer a longer-dated note, you get better terms. So we have a seven-year note here, which is quite long," he said.

"But on the other hand, you're getting a pretty aggressive payout. The 255% upside participation is pretty high. The removal of the cap is great if you're bullish.

"But the notes do not offer any protection on the downside, not even a barrier, and the question is why. Why would investors consider this type of structure?

"Maybe they feel that seven years is long enough not to need the protection. There is still a risk in making that assumption, but for a lot of people, it's more important to have a protection on a two-year than on a seven-year.

"On a seven-year, they may be happy to carry that risk. They have some significant leverage, no cap. They're going to outperform if the market is up. And that's what they want. That's also what will give this product a very high return score."

The key metrics of risk, return and price are measured through various scores established by Future Value Consultants. The research methodology generates reports designed to assess the quality of a product compared to other products of the same type. In this case, the product type is leveraged return. The category includes all notes with an upside participation greater than 100%.

High market risk

The risk associated with a structured note is measured by Future Value Consultants' riskmap. The rating measures the risk on a scale of zero to 10 with 10 being the highest level of risk. The riskmap is obtained by adding its two sub-components: market risk and credit risk.

The product's riskmap of 6.26 is higher than the 3.22 average score for the structure type, according to Future Value Consultants' report

While the notes are slightly riskier on the credit scale (the credit riskmap is 0.78 versus an average of 0.63), most of the extra risk comes from market risk as illustrated by the 5.48 market riskmap, which exceeds the 2.59 average for the same product type by almost three points, the report showed.

"This is due to the lack of any protection on the downside," he said.

Top risk-adjusted return

Future Value Consultants measures the risk-adjusted return with its return score. 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.

"We look at different scenarios. This one is bullish. Under the bullish scenario, this product will score well because there is no cap and there is a high participation," he said.

Indeed, the report showed a 9.27 return score on the zero to 10 scale. In comparison, the average return score for leveraged return products is 7.76.

Under the bullish scenario, Future Value Consultants' probability chart reveals that investors have a 70% probability of generating a profit and a 30% chance of losing money. The probability of a high return in excess of 15% a year is high at 24.4%, while the odds of losing by the same amount are 5.6%.

Modest value

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The report shows an unusually low price score of 0.91. In comparison, the average price score for leveraged return notes is 7.59. The average for all products across all structure types is 7.07.

"Our model doesn't give it a very good price score. We think it's quite expensive. We've seen better value trades elsewhere," he said.

"Some value should have been spent on protection or even on more leverage. The seven-year maturity is significantly long, especially with a high-yielding index, which has to be taken into account."

The Euro Stoxx 50 has a dividend yield of 2.75% versus a 1.85% yield for the S&P 500 index.

The product offers the particularity of exhibiting a strong contrast between a high return score and a low price score, he noted.

"Price and return scores tend to move in the same direction, although not always. In this case, there is a striking difference. The explanation lies in the optimal assumption we choose to run the return score. Under the bullish assumption, because the product is long-dated, highly leveraged and uncapped, if the market performs well, the notes will perform extremely well," he said.

"In contrast, we don't use an optimal scenario to compute the price score. We just look at the price of the assets today, so it's a different metric."

Overall score

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

The notes carry an overall score of 5.09, compared with an average overall score of 7.67 for leveraged return products.

"Despite the very high return score, the overall score is low. It's affected by the low price score," he said.

HSBC Securities (USA) Inc. is the underwriter.

The notes will price and settle in April.

The Cusip number is 40432XYJ4.

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