HSBC’s barrier notes tied to S&P 500 offer hedge, alternative to index, but tenor may be short

By Emma Trincal

New York, Jan. 4 – HSBC USA Inc.’s 0% barrier participation notes due Jan. 29, 2019 linked to the S&P 500 index offer unlimited upside and barrier protection over a three-year period, terms a wealth adviser found attractive on the S&P 500 index.

But another adviser said the three-year tenor combined with the contingency of the downside protection may be too risky.

If the index finishes at or above the initial level, the payout at maturity will be par plus at least 100% of any gain, according to an FWP filing with the Securities and Exchange Commission.

If the index falls by up 25%, the payout will be par.

Otherwise, the payout will be par plus the index return, with full exposure to losses.

Hedge

“I like it,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“The S&P is always a core position. No matter what type of portfolio you have – conservative or not –you’re always going to be invested in it. Any time you have equity in the portfolio, you’re going to start with blue chips.”

He compared having a long position in the index fund with owning the notes.

“If I’m long the index, my note will perform like the index on the upside since there is no cap.

“But on the downside, I’m one-to-one with the index while I can be down 25% and still be good with the note.

“It’s all upside for me. I don’t see any reason not to use the note.”

The cost of the investment could be one such reason, but Kunhardt said he was comfortable with the fee, which will be 1.2% or less.

“I prefer under 1% for the fee, but I can go 1.2%,” he said.

“I’m essentially buying a hedge. That’s all I’m doing.”

The adviser said he also liked the duration.

“I’m almost agnostic because I would hold the S&P anyway. Even five years wouldn’t have been too long,” he said.

Yet the three-year term offers some advantages.

“It’s a good timeframe. I can amortize the cost, and at the same time, I’m not locked in for an unreasonable amount of time.”

Good scores

Michael Kalscheur, financial adviser at Castle Wealth Advisors, had a mixed view.

He saw the uncapped payout, the tenor, the underlying index and the issuer’s credit as attractive.

On the other hand, both the barrier and the tenor make investors too vulnerable to the risk of losing some principal, in his view.

“I’m very familiar with HSBC. They’re at the top of the class in terms of credit. They’re definitely on our approved list,” he said.

“The structure is straightforward. A straight-up three-year [term], one-to-one on the upside, uncapped, which is a big thing for us.

“It’s the S&P without the dividends. It’s very easy to understand. No issues here.

“The 1.2% fee works out for me. It’s very cost-effective, very efficient; that’s why we like these guys.”

Barrier

But Kalscheur, who tends to prefer buffers over barriers, was not comfortable with the downside risk.

“The one part I’m not excited about is the barrier. The risk of a 25% decline over three years is too high. If we were talking about a five-year term, it would be different,” he said.

Kalscheur said his view was based on a study his firm ran that tracked the historical performance of the S&P 500 in order to measure probabilities of losses or gains over preset rolling periods.

“I’m not giving you just my impression. This is based on statistics we’ve taken back to 1950,” he said.

“If you go back 65 years and you take five-year rolling periods, there is less than 1% of a chance to see a decline of at least 25%. If you shorten the timeframe to three years, that number jumps up to 4.6%. That’s a big difference.

“When we offer structured notes to our clients we’re selling downside protection. If the stock market turns badly, at the base level you are protected on the downside. Worst-case scenario, if you had a five-year note, you would have a 1% chance of breaching the 25% barrier, but if it’s almost a 5% chance, that’s a little bit more than I’m willing to stomach because the reason I’m doing structured notes is for the downside protection.”

Kalscheur explained that over short periods of time, he prefers buffers.

“I would rather have a 10% or 15% buffer than a 25% barrier on a three-year. Otherwise, if I must have a barrier, I would go from three-year to five-year so I can reduce my risk from 5% to 1%. That’s an 80% reduction,” he said.

Probabilities of breach

With his study, Kalscheur measured the probability of the S&P 500 declining by at least 25%, comparing three-year rolling periods with five-year rolling periods on a trading day-to-trading day basis.

For the three-year results, the study showed 15,732 day-to-day three-year rolling periods. Based on this sample, a barrier breach at the end of the three-year period happened 716 times. Dividing the number of occurrences by the number of rolling periods gives a risk of losing principal of 4.55%.

For the five-year results, the number of day-to-day five-year rolling periods was 15,227 and the index fell to or below the 25% barrier 129 times, which generated a less than 1% probability.

“This has nothing to do with HSBC, the fees or the S&P. It has to do with risk and the term of the notes,” he said.

“I can’t look a client in the face and get excited about a 25% barrier.

“A 5% risk is too much risk to take on. I can’t do it. That’s not why I’m buying structured notes.

“I might do it on a five-year, but not on a three-year.”

HSBC Securities (USA) Inc. is the agent.

The notes will price on Jan. 26 and settle on Jan. 29.

The Cusip number is 40433UFU5.

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