HSBC’s Market Index Target-Term Securities linked to Dow show limits in pricing protection

By Emma Trincal

New York, Nov. 23 – HSBC USA Inc.’s 0% Market Index Target-Term Securities due December 2023 linked to the Dow Jones industrial average are fairly priced, sources said, but the economics for principal protection structuring continue to make pricing those products difficult.

Only 225 offerings of equity-linked notes with full downside protection have priced so far this year, according to data compiled by Prospect News. It’s a notional of $645 million, which represents less than 2% of total volume.

Sources said those numbers are not surprising: pricing those products has become a real challenge in recent years.

The notes at maturity pay par of $10 plus any index gain, subject to a maximum return that is expected to be 40% to 50% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index return is zero or negative, the payout will be par.

The final index level will be the average of the index’s closing levels on five trading days shortly before maturity.

Terms and pricing

“There is still demand for principal protection of course, but the pricing remains difficult in this rate environment. Yields may be up; they are still at historical lows,” said a market participant.

Investors in the notes have to forego the dividends, as it is the case with most structured notes. But over a long period, those non-payments compound into a significant opportunity cost, he said.

The Dow has a dividend of 1.82%. For investors, it represents a 12.75% “loss” of return compared to buyers of the exchange-traded fund replicating the index.

“You’re giving up all these dividends, and your upside is capped. But this is nothing new. There isn’t much room to price the options,” this market participant noted.

“You can’t add some leverage on the upside or raise the cap given the interest rate levels that we have.

“Until rates move up significantly, you’re not going to be able to avoid those caps and extended maturities.”

Demand

But the deals continue to get priced.

“The terms on those deals may not look great, but there’s always going to be people looking for protection,” he said.

“It is what it is.”

An industry source said the terms of the notes are relatively standard.

But he said he hopes the market will soon improve and enable issuers to better price those products.

Principal-protected notes are zero-coupon bonds issued at a discount. This guarantees that the principal will be repaid at maturity. But when the discount is too narrow due to low interest rates, structurers have very little room to purchase the call options required to offer compelling returns, he explained.

“Rates have begun to rise since July, and they’ve jumped since the elections. Many are starting to predict that rates can only go up from now on,” he said.

“We should see more principal-protected deals in the near future. I think we’re going to see higher caps on these.”

BofA Merrill Lynch is the underwriter.

The notes are expected to price and settle in December.

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