HSBC’s autocall contingent income notes on Alibaba offer short-term income prospect

By Emma Trincal

New York, Oct. 5 – HSBC USA Inc.’s 8.5% autocallable contingent income barrier notes due Jan. 9, 2020 linked to Alibaba Group Holding Ltd. are designed for aggressive income investors who want to use the volatility of the underlying stock to generate income over a short period of time, said Almudena Rojas, structured products analyst at Future Value Consultants.

Each quarter, the notes will pay an 8.5% contingent coupon if Alibaba stock closes at or above the coupon trigger level, 65% of the initial share price, on the observation date for that quarter, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par plus the coupon if the stock closes at or above the initial price on any quarterly call observation date beginning April 4, 2019.

The payout at maturity will be par plus the final coupon unless the stock closes below its 65% barrier price on any day during the life of the notes, in which case investors will be fully exposed to the decline in the stock.

65% barrier

One of the ways to increase the odds of receiving the coupon is by placing the barrier at a relatively low level, she said. But “low” is relative as it is a function of the risk incurred.

Volatility

“We have here a combination of two significant risk factors: a highly volatile underlying stock and the type of barrier used, the American barrier,” Rojas said.

The implied volatility of the American Depositary Shares of the Chinese internet company is 30.7%.

In comparison, the S&P 500 index implied volatility is at around 16%.

“The volatility is high, which is why they can offer a quite decent barrier level of 65%,” she said.

American option

“If you had the same barrier on the S&P 500, it would be too expensive to price,” she said.

To make the pricing work, especially on such a short tenor, they had to introduce an American barrier, she added.

A so-called “American barrier” is one that can be monitored during the life of the notes – in this case daily – as opposed to the more typical European barrier, observed only once, at maturity.

Expectations

“The level of the barrier is reasonable but the type of barrier is risky. With a volatile stock like Alibaba, investors take the risk of not getting paid. They might also lose some of their principal at maturity if they don’t get called.

But this should fit the investors’ profile.

“They want the income but over a short period of time and they don’t really care if the stock is negative as long as it doesn’t breach the barrier.

Buyers of the notes must have the conviction that the stock price will not drop by more than 35% at any time. However, they do not have to be necessarily bullish.

“All you want is to stay above the 65% barrier at all times.”

Early redemption early

The autocallable feature offers a six-month call protection, which allows investors to get paid half of the annual coupon rate even if the stock is above its initial level.

The first call date therefore coincides with the second coupon payment, a point in time after six months, in which the probabilities of an automatic call are the greatest.

Rojas illustrated this point using Future Value Consultants’ stress testing methodology.

The research firm produces stress-testing reports on structured notes allowing investors to assess the probabilities associated with a variety of different mutually exclusive outcomes. The data is organized around 29 different tables, which can be customized.

Two coupons

One such table, the “product specific tests,” showed a 48.75% probability of getting called at point 1 (six months after the initial pricing). This date is linked to a 51.64% chance of collecting two coupon payments – one on the first quarter, the second upon the early redemption.

“This is the most likely outcome, which investors are betting on. Most likely, you’ll get paid twice and kick out after six months,” she said.

Probabilities of losses

On the negative side, the occurrence of a barrier breach showed a relatively high probability of 19%, according to the table.

This event shows almost the same probability as the loss of principal, which happens 18.56% of the time.

“It’s not for the conservative investor. About one out of five times, you will lose money,” she said.

“We can attribute this result to the type of barrier. If it were a European barrier, the chances of breaching would only be 10%.

“By simply using the American barrier, you add a significant amount of risk.”

Other scenarios

These probabilities apply to Future Value Consultants’ neutral scenario, which is calculated from the risk free rate. Other scenarios, including bear, bull, low volatile and more volatile are also included in the report. They use conservative assumptions for the volatility and the growth of the underlier.

Under the bull scenario, the capital performance tests showed a 12.57% chance of losing principal at maturity versus 25.39% in the bear scenario. The “more volatile” assumption results in a high probability of losses as well, 23.67% of the time.

Similar to the bull market, the less volatile scenario displayed a much more pleasing probability of losses at 11.95%.

“In both the bear and volatile markets there will be similar chances of losing capital due to the increased risk of breaching the barrier,” she said.

Think it through

Those probabilities suggest that investors should pay attention to the risk volatility combined with a daily observation represent even when the protection threshold seems reasonable.

“Barriers matter,” she said.

“It’s always a tradeoff between getting attractive terms and taking on more risk.

“With a highly volatile stock such as this one, the issuer had to make the barrier American in order to price the deal in a way that can be appealing to investors.

“Both the bull and the less volatile markets are the most suitable for this product.

“Investors should take the stock trend into account and make sure they are comfortable with the risk involved.”

HSBC Securities (USA) Inc. is the agent.

The notes will settle on Wednesday.

The Cusip number is 40435F5D5.

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