Time is main issue with HSBC’s buffered uncapped leveraged notes tied to EAFE ETF, sources say

By Emma Trincal

New York, Feb. 21 – HSBC USA Inc.’s 0% leveraged buffered uncapped market participation securities due Feb. 24, 2022 linked to the iShares MSCI EAFE exchange-traded fund offer most of what investors would be looking for in a return enhancement note except the longer duration, according to buysiders. The question is whether it makes sense to accept the five-year tenor as the condition for what, those advisers said, are otherwise good terms.

If the ETF return is positive, the payout at maturity will be par plus 1.4 times the ETF return, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the fund falls by up to 25% and will lose 1% for every 1% decline beyond the buffer.

Time

“I like these kinds of notes because the only trade-off you’re doing is time,” said Jerry Verseput, president of Veripax Financial Management.

Structured notes always have a trade-off. Having a cap can be a trade-off too, he said.

“Here it’s just time. You have to hold it for five years. Assuming you’re invested in stocks, you should have five years anyway. Meanwhile, you have uncapped leveraged upside plus a 25% buffer on the downside. I think it makes sense.”

Credit

Verseput was not concerned about credit risk exposure.

“HSBC is highly rated. It’s a very tiny risk you’re taking compared to the market risk.”

The five-year credit default swap spreads for HSBC are 65 basis points, which is the same as Bank of America’s and slightly equal to Citigroup’s 66 bps, according to Markit.

Other U.S. banks such as Morgan Stanley (80 bps) and Goldman Sachs (83 bps) have much wider spreads.

Barclays, the other large U.K. issuer, shows CDS spreads of 76 bps, according to Markit.

Leverage

Despite those advantages, Verseput said that he would still try to improve the structure.

“I think we would negotiate a better note, but it’s perfectly fine considering that it’s a publicly offered note.”

He said he usually wants at least 1.5 times leverage for foreign stocks, as they are more volatile.

He noted that he would probably choose another index given the high dividend yield of the MSCI EAFE index, which is 2.97%. Noteholders do not receive dividend payments.

“That’s kind of high. You would have made 15% over the five years with the index,” he said.

“This is why they won’t give as much leverage ... because a high-dividend underlying like that will be less volatile.

“I’d probably be looking for a more volatile index so I could get more leverage and more protection.”

Protection

But the 25% buffer is very attractive, even with the no dividend payments, he noted.

If the market drops 40%, for instance, investors would “beat” the index by 25% minus 15% in dividends. As a result, they would still be “ahead of” the market by 10%.

“For people worried about a strong downturn but who still want the exposure to this ETF, this is appropriate,” he said.

“If I was going to do a customized note, that’s not the index I would pick, but it can be perfectly fine for other types of investors or situations.”

Unusual

For Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, “time” is more of an issue despite the attractiveness of the product.

“Conceptually, I like the notes a lot,” he said.

“It’s unusual to see a levered note on a major asset class with both uncapped upside and a significant buffer on the downside. And it’s a hard buffer. We like that a lot,” he said.

The issuer’s credit is “pretty good,” he added. Also, the asset class offers attractive valuations.

Value

The total return over a five-year trailing period as of Friday was 5.35% for the iShares MSCI EAFE ETF versus 13.85% for the S&P 500 index, according to Morningstar.

“From a valuation standpoint, one could strongly argue that the EAFE is an asset class to consider,” he said.

“Doing it with HSBC with uncapped upside and a buffer along with leverage seems very compelling.”

Tenor

However, Foldes would have no use for the notes.

“Tying up our clients’ money for five years is always problematic,” he said.

Instead, he would consider redesigning the structure in an effort to give it a shorter tenor.

“We recognize that leverage may be lower. There may be a cap ... hopefully a high cap ... and chances are the 25% buffer would be less.

“But beyond two years, it’s problematic for us.”

Shorter

The concern with longer duration is also related to dividend loss. As the notes extend in time, the loss of dividends increases and makes the product less competitive compared to a direct equity investment that offers the total return, he explained.

“That’s a problem. You’re losing 15% over the five-year period,” he said.

“It’s significant compared to the 2% yield on the S&P.”

But the “deal-breaker” is simply the long holding period independent of the fact that it creates a greater amount of “lost” dividends.

“For us, the non-starter becomes the term of the notes.

“A five-year note is way too long. This term is a killer.”

HSBC Securities (USA) Inc. is the agent.

The notes will settle on Friday.

The Cusip number is 40433US23.

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