Longer tenor of HSBC’s leveraged notes linked to S&P 500 help price buffer, uncapped gains

By Emma Trincal

New York, Oct. 31 – The seven-year tenor of HSBC USA Inc.’s 0% buffered accelerated return notes due Nov. 26, 2021 linked to the S&P 500 index is longer than the average tenor for a leveraged note, but investors in exchange benefit from relatively attractive terms, in particular the absence of a cap and a “large” buffer, said Tim Mortimer, managing director at Future Value Consultants.

The payout at maturity will be par plus at least 1.35 times any index gain. The exact rate will be set at pricing. Investors will receive par if the index falls by up to 30% and will lose 1.4286% for each 1% decline beyond 30%, according to an FWP filing with the Securities and Exchange Commission.

‘Juicy terms’

“You have quite juicy terms because it's such a long maturity compared to the standard leveraged product, and that usually benefits the pricing of it,” he said.

“The upside is attractive with a high participation rate. You get 135% participation on the upside, no cap and a pretty large buffer.

“On a seven-year period, people do not expect the market to drop 30% even if it could. From a pricing point of view, there is still risk below 30, which is why they can generate the upside.

“If it was a three-year note, a buffer of that size would wipe out the upside.”

Geared buffer

An investor buying the notes would reason that “even though the S&P is at an all-time-high right now, it’s hard to imagine quite a dramatic plunge,” he said.

“Most people don't anticipate such a correction over that long period of time.

“It's also a buffer, not a barrier. If the S&P is down 40%, you lose some money, but it's not an awful lot of money.”

The downside “gearing” at 1.4286 is “quite high,” he said, but it’s “still better” than a barrier.

If the index fell by 40% at maturity, investors would lose 14.85%, he said as an example.

“The downside leverage is there to give more value. The 1.42 multiple derives from the calculation that allows the structure to bring down your principal to zero if the index falls below the buffer level all the way down. That’s how you can lose your entire principal even if the asset declines by only 70%,” he said.

“It doesn't undo the benefits of having a buffer. It just means that once you are below 30, you start to lose principal at a quicker pace. It's just a way to get more value.

“You obtain this ratio by dividing the principal value by the portion beyond the buffer, where the leverage applies,” he explained, which is 100 divided by 70.

“Most of the value is not generated by the downside risk but by the effect of the risk-free rate and funding, and rates over a longer period of time help here.

“This note is for investors who are prepared to take a long-term view in the equity, people who are looking for some downside protection but don't see that much risk below 70%. Just as important: they want to get the full enhanced return,” he said.

Market risk

In its research, Future Value Consultants assesses risk, return and price using a variety of proprietary scores in order to compare a product to others.

Most of the scores of the HSBC notes are significantly above average, according to Future Value Consultants’ research report. Only the market risk score, or market riskmap, is average.

The market riskmap is one of the two components of the riskmap, the firm’s rating of risk.

By adding market riskmap and credit riskmap together, Future Value Consultants generates the riskmap, its measure on a scale of zero to 10 of the overall risk associated with a product. A score of 10 represents the highest level of risk possible.

The firm’s report shows a 2.56 market riskmap versus an average score of 2.77 for products of the same type.

“We have less market riskmap than comparable products, which include all leveraged notes with or without protection. It's somewhat surprising since the buffer looks quite large,” he said.

“It's perhaps because 1.42 gearing on the downside is a lot higher than one, and that takes out some of the benefits of the buffer.

“The impact of the long tenor should be fairly neutral on market risk. We see that the market riskmap is a little bit lower than the average for the same product type but not by much.

“This 30% buffer on a seven-year is not the same as a 30% on a shorter maturity. As juicy as it sounds, this 30% protection is probably the equivalent of a buffer of 20% on a shorter-term product.”

Other conditions related to the term benefited pricing, he said.

“The volatility curve in the market for the S&P will be higher for longer maturities. The one-year volatility on the S&P is not the same as seven-year,” he said.

“People when they enter that trade make the assumption that the S&P is not going to be down 30% in seven years.

“What's true in the pricing and what's true in people's perception is not necessarily the same thing though.

“From a pricing standpoint, the seven-year volatility is higher, hence you have greater risk.”

The credit risk for the notes is 0.96, compared with 0.56 for the average of the same product type.

“Credit risk is pretty high compared to similar products. That's probably due to the fact that this maturity is longer than average. HSBC has a pretty good credit, but the maturity factor here offsets the creditworthiness factor,” he said.

Bullish scenario

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.

The notes have a 9.30 return score, compared with 7.76 for the average of all leveraged notes rated by the firm, the report shows.

With these notes, the best market assumption is bullish, he said.

Under this scenario, Future Value Consultants’ probability chart reveals that investors have an 11.6% probability of losing money versus an 88.4% chance of generating a positive return.

“It’s a pretty high return score. But it’s not too surprising. When you take a longer-dated note under a bullish scenario, you have a longer opportunity for the index to take off. Add to that a higher participation with no cap, it will make a difference,” he said.

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 price score for the notes is 8.96. For similar products, the average is 7.63, according to the report.

“The price score is very high. Duration, this time again, is an important factor,” he said.

“When we calculate the price score, we spread the fee on an annualized basis. With a seven-year term, that fee is spread across a longer maturity. In other words, the issuer is taking up less per year.”

Overall score

To conclude its report, Future Value Consultants determine for each product its overall score, which measures the firm’s general view on the quality of a deal. It is the average of the price score and the return score.

The notes have a 9.13 overall score versus 7.70 for the average for the same product type.

“The overall score is very strong. Both the price score and the return score contribute to this. This product is significantly better than most,” he said.

HSBC Securities (USA) Inc. is the agent.

The notes will price Nov. 20 and settle Nov. 25.

The Cusip number is 40433BTE8.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.