HSBC’s $4 million lookback allocator notes linked to three indexes seen as correlation play

By Emma Trincal

New York, March 18 – HSBC USA Inc.’s $4 million of 0% lookback allocator notes due Sept. 18, 2019 linked to the S&P 500 index, the Euro Stoxx 50 index and the Hang Seng China Enterprises index offer investors a maximum allocation to the best-performing index of the three with declining weightings as performance worsens, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 60% of the return of the best-performing index, 30% of the return of the second-best-performing index and 10% of the return of the worst-performing index. The notes are not principal protected, so the payout could be less than par.

Complexity

Mark Dueholm, chief trader at Landolt Securities, said the complex structure meets a growing demand for non-U.S. equity exposure.

“That’s probably a little bit more complicated than what most investors are looking for. It wouldn’t be appropriate for the average retail investor. Maybe for somebody more sophisticated looking for exposure to foreign indexes,” he said.

“The U.S. is about the worst-performing market this year. Clearly a lot of people are looking for alternatives in international equities.”

Other formulas

A market participant said this type of product has not been seen a lot of late. He explained the term “lookback” used to name the product.

“You look at the overall performance at the end and ‘look back’ to apply a 60% weight to the best, 30% to the second best and 10% to the worst,” he said.

“I haven’t seen those in a while.

“We’ve done a similar note in the past, but it was linked to a basket of assets, not just equity indexes. You had an equity component, a bond component and a third asset class. At the end, you were getting the return of the best-performing portfolio. Each was weighted differently. One was heavily weighted in bonds.

“Interestingly, it didn’t make a whole lot of difference. They all performed pretty similarly. Typically bonds and stocks move in opposite directions. But we had a unique market in the last six years. Bonds and stocks have been moving in the same direction. The portfolio heavily weighted in bonds did extremely well. So did the one with a strong allocation to stocks.”

This example, he said, illustrates the importance of correlation when the payout is allocated to one among several underlying assets.

Worst or best

“Whether you look at a worst of or a best of like this one, the main thing to watch is correlation,” he said.

“These three indexes, the Euro Stoxx, the S&P and the Hang Seng, obviously have some correlation to each other.

“The [more] highly correlated they are, the easier it is to put the structure together. If they’re highly correlated, that doesn’t really add a lot of benefit or risk to the structure. It’s when correlation is low that you get the most benefit from these types of payouts.

“If you wanted exposure to gold and equities for instance – typically two inversely correlated assets – you would probably get more potential return.

“Just because this note is more heavily weighted to the best of the three indexes doesn’t mean you’re getting a huge advantage. All of them could very well be moving in the same direction, and then what?

“With those types of payout, it’s the worst- or the best-performing index in a group of several underlying assets that will drive your return or coupon. Obviously, you get paid more if the risk of them moving divergently increases.”

Correlation

The S&P 500, the Euro Stoxx 50 and the Hang Seng China Enterprises may not be highly correlated, he said. Whether the correlation is high or not, any investor in the notes should have a view on correlation.

“Maybe there is less correlation between the U.S. markets and foreign assets than ever before because of the ill timing of the central banks’ interventions worldwide,” he said.

“The U.S. is coming out of its monetary stimulative policy, unwinding its QE program, and the talk here is about the timing of an interest rate hike, while Europe and Japan are entering a new phase of stimulative actions.

“That creates a divergence, which is now highly visible in the currency market with the dollar rising strongly against the euro.

“The same divergence may manifest itself on the equity side. There may be less correlation over the next few years between the U.S. and the international equity markets. Maybe investors who bought that note have that view. If that’s the case, the more-than-four-year term is a reasonable timeframe for this scenario to play out.”

The notes (Cusip: 40433BH84) priced March 13.

HSBC Securities (USA) Inc. is the agent.

The fee is 2%.

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