HSBC’s buffered S&P 500-linked notes a peculiarity: reverse convertible tied to single index

By Emma Trincal

New York, Aug. 26 – HSBC USA Inc. plans to price 3.6% to 3.9% buffered notes due Sept. 8, 2021 linked to the S&P 500 index, according to an FWP filing with the Securities and Exchange Commission.

Interest will be payable quarterly.

The payout at maturity will be par unless the index falls by more than 20%, in which case investors will lose 1% for each 1% that the index declines beyond 20%.

“It’s not that common to see a reverse convertible on one index,” said Tim Vile, structured products analyst at Future Value Consultants.

“Usually reverse convertibles are short-term ... less than one year. ... They may have no downside protection. When they do offer protection it tends to be through an American barrier, which carries more risk ... and they are almost always linked to a single stock,” he said.

“This one is the complete opposite: five-year, a 20% buffer, and for the underlying ... a plain-vanilla benchmark.”

American barriers are monitored during the life of the note instead of at maturity only, which increases the risk.

Future Value Consultants evaluates risk, return and price using a variety of proprietary scores in order to compare a product with its peers as well as the rest of the market. In this case the number of reverse convertibles with a fixed coupon is too small to allow the rating of this product against its peers. The notes therefore were assessed versus all notes across all structure types that have been recently rated.

Dividends

While 3.9% a year does not seem like a lot, it is attractive for investors who need a guaranteed coupon, said Vile.

The S&P 500 is less volatile than most underlying stocks used in typical reverse convertibles, he noted.

Because reverse convertibles sell volatility to generate the yield, a less volatile underlying, such as the S&P 500, may prove to be a challenge for the pricing of the notes.

“They probably were able to use the dividends over five years to overcome the fact that selling puts was not going to be worth a big premium compared to doing that on very volatile stocks,” he said.

The S&P 500 carries a 2% dividend yield, which noteholders do not receive.

“Including the dividends over a long maturity helped the pricing,” he said.

Low riskmap

The firm calculates the market risk and the credit risk and adds the two components to generate the “riskmap,” which measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible.

The notes have a 0.83 market riskmap versus an average of 1.68 for all products, according to Future Value Consultants’ research report.

“This note was built for relatively conservative investors. A 20% buffer is a significant size, especially on the S&P,” he said.

“This is for someone who wants a fixed coupon and who is happy with it.”

The credit risk is relatively greater since the longer tenor increases the probability of a credit event or default, he noted.

Indeed the credit riskmap is 0.92 versus an average of 0.49 for all products, the report showed.

“HSBC’s credit is reasonable. It’s the longer term of the notes that’s increasing the credit risk,” he said.

HSBC has credit default spreads of 71 basis points, much lower than Barclays’ 92 bps, according to Markit. Those spreads are also tighter than most U.S. banks with the exception of JPMorgan, which shows spreads of 59 bps, and Wells Fargo, 49 bps, according to Markit.

Adding the two risk components generates a riskmap of 1.74, compared with the average of 2.17 for all product types, according to Future Value Consultants’ research.

“Even with a higher credit risk, we still have a good riskmap, one that’s better than average,” he said.

Return score

The risk-adjusted return of a note is measured with Future Value Consultants’ return score. The research firm reviews five different market scenarios and picks the best of those in order to compute the score. In this case, the score derives from a low-volatility market assumption since investors are guaranteed their coupon and will receive their principal at maturity as long as the market does not decline by more than 20%.

The return score is 7.24 versus an average of 7.14 for all products.

“This is very close to average, although a bit lower. Despite the very low risk, you’re still limited on the upside. You’re not going to get more than 4% a year. It’s still reasonable, and the low riskmap helps a lot. But you’re comparing this with many other notes that offer much higher returns and in some cases no cap,” he said.

High 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 9.78 price score is much higher than the average for all products, which is 8.32.

Vile noted how the return score and price score diverged.

“With the price score you’re looking at what the issuer has been buying for investors, how much they spent on the option. It’s quite a lot. You have a 20% buffer; you still have a guaranteed coupon. It’s tied to an index, not a stock. A lot is in there,” he said.

Another factor is the long duration of the notes, which favors price scores in general.

As fees are calculated on an annualized basis, a longer term allows the cost to be amortized over a longer period of time, hence delivering more value to the investor.

Overall score

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 have an overall score of 8.51 versus 7.73 for the average of all product types.

“You get almost 4% a year. It’s still reasonable for a guaranteed coupon tied to an index.

“This deal scores very well. There is less risk than average, and you still get a decent return. The fixed rate should appeal to some of the conservative fixed-income investors, even though your principal is still at risk.

“The return is tied to a broad benchmark, not to a high-flying stock, and you have a pretty large buffer.

“It’s quite a good product for investors looking for a fixed coupon and who are willing to go five years.”

HSBC Securities (USA) Inc. is the agent.

The notes will price on Sept. 2 and settle on Sept. 8.

The Cusip number is 40433UTT3.

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