HSBC’s autocall step-ups tied to Russell 2000 aimed at mild bulls, show risk at maturity

By Emma Trincal

New York, March 3 – HSBC USA Inc.’s 0% autocallable market-linked step-up notes due March 2020 linked to the Russell 2000 index offer investors a chance to outperform the benchmark in a flat or mildly bullish market with a guaranteed minimum return and no cap on the upside.

“This trade is for an investor who thinks the Russell is going to be flat to slightly up, enough to finish above its initial price in three years,” said Tim Mortimer, managing director of Future Value Consultants.

“This is how you can either get the call premium or the coupon at the end.”

Autocall

The notes will be automatically called at par of $10 plus a call premium if the index closes at or above the initial index level on either annual call observation date, according to an FWP filing with the Securities and Exchange Commission The call premium is expected to be 9% to 10% per year and will be set at pricing.

Mortimer assumed a call premium at midpoint or 9.5% a year to run his stress-testing model.

The automatic call is the least risky outcome as the chances of losing money are much higher at maturity, he said.

Maturity

If the notes reach maturity and the final index level is greater than the step-up value, 130% of the initial index level, the payout will be par plus the index return.

If the final index level is greater than or equal to the initial level but less than or equal to the step-up value, the payout will be par plus the step-up payment, 30%.

If the final index level is less than the initial level, investors will have one-to-one exposure to the decline.

“The most desirable outcome is if the notes mature. But this is where the risk is the most tangible,” he said.

“Investors in those notes should not assume that just because there is a minimum 30% coupon and no cap, they don’t take a lot of risk of losing money. They do.”

Stress-testing

The structure is atypical in that it is an autocall, a digital and a participation note all at once.

“It’s a bit complex, so we treated the product as an autocall with two call points,” he said, commenting on his stress-testing model.

The step-up at maturity was defined as a 30% coupon above 100 but below 130.

Naturally the potential gain above the 130 step level was also taken into account in the calculations of the probabilities of return outcomes.

Beware the end

“You start at 100. If you’re called at point one, which is year one, you get 109.5%; point two, 119%. If you’re not called at maturity and you’re up but below 130, you get 30%. So if you’re up, you get at least 30% and you can get more,” he said.

“Obviously the idea of not being capped above the digital is what makes the structure appealing.”

“The most appealing scenario if you want the full coupon is to remain in the notes until maturity. “Unfortunately, you want to finish above 100, and it’s not easy.”

The chances of finishing above 100 after three years without having been automatically called on year one and year two, were slim.

“Think about it this way: you’re not called. Year one, you’re below 100. Year two, you’re still below 100. Statistically, the probabilities of closing above 100 at the end of the third year are low. If you don’t get called at first, it becomes harder and harder,” he said.

Scorecard

To illustrate his point, Mortimer pointed to his report’s scorecard. This table shows different and mutually exclusive outcomes of product performance with their respective probabilities of occurrence.

The most likely scenario is an autocall event on the first call point with a probability of 53.15%, which gives a 9.5% return, according to the scorecard. The odds of getting called a year later are lower at 13.12%.

“If one looks back at the Russell’s performance, the chances of hitting the first call date are much higher,” he said.

The backtested scorecard for the last five, 10 and 15 years offer a different picture.

For the past five years for instance the probability of a call on point one rises to 87% compared the 53% in the implied scenario.

“This is not surprising given the strong bull market we’ve had over the past five years,” he said.

But it also played out over the past 15 years, despite the 2008-09 bear market.

For that timeframe, the chances of a “first call” were 69%.

Maturity outcomes

Once the two dates for an automatic call have past, the notes will mature.

In such case, three possible outcomes are analyzed.

The first one is the loss scenario, in which the Russell 2000 index finishes below 100. The probability assigned to that outcome is 28.45%.

“Remember: this is an autocall without a barrier, which is unusual. Most autocalls have barriers,” he said.

In the second scenario, investors receive the 30% digital (step-up payment) because the index finishes between 100 and 130.

“This is the digital payout. That’s the most attractive outcome,” he said.

Instead of getting 9.5% on the first call or 19% on the second, investors receive 30% at the end.

In such situation, investors are guaranteed to outperform the price return of the index.

“That’s the return enhancement feature of the product. It’s what you want to achieve. It’s also the less likely outcome,” he said.

The probability of receiving the step-up payment is only 4.87%, according to the scorecard.

Finally the third scenario – long, uncapped exposure above the step-up – is the less likely to occur with a 0.41% probability.

No call, high risk

Mortimer proceeded to calculate the probabilities of “staying in the structure” until maturity, which is the sum of the three final scenarios: 28.45% for capital loss; 4.87% for digital payout; and a 0.41% for the one-to-one exposure to the benchmark.

“There is approximately a 34% chance of not being called, in other words a chance out of three of staying in the note all the way to the end,” he said.

“If this is the case, the odds of losing money are very high.”

Taking the 28.45% general probability of losing money in the notes and dividing it by the 34% chance of “staying in the structure” for the full term, investors, if no call occurs, can expect to lose money in nearly 84% of the time, he said.

Big picture

This high probability is only if no call occurs. In that scenario, risk and reward are high.

“You can see that intuitively. If you’re not called two years in a row, it’s going to be harder to be above 100,” he noted.

“You only need to be flat to get the coupon but as you’ve eliminated the chances of an early redemption, the gap between the index level on average and 100 is likely to increase.

“Your best opportunity is to be called if you want to minimize risk.

The probabilities of losses were made much greater due to the lack of downside protection in the structure.

“They don’t give you a barrier. You get 30%. It’s pretty big. But the issuer can’t be paying for both at the same time.”

“What’s the most attractive in this product is by far the least likely to occur,” he said.

BofA Merrill Lynch is the agent.

The notes will price in March and settle in April.

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