HSBC’s autocall contingent coupon notes tied to stocks offer alternative to single asset play

By Emma Trincal

New York, Jan. 11 – HSBC USA Inc.’s autocallable contingent income barrier notes due Jan. 30, 2020 linked to the lesser performing of the common stocks of AT&T Inc. and Verizon Communications Inc. illustrate the advantage of introducing a worst-of payout in order to enhance returns, said Suzi Hampson, head of research at Future Value Consultants.

Each quarter, the notes will pay a contingent coupon if each stock closes at or above its coupon trigger level, 75% of its initial share price, on the observation date for that quarter. The contingent coupon rate is expected to be 9% to 9.75% per year and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if each stock closes at or above its initial share price on any quarterly call observation date.

The payout at maturity will be par plus the final coupon unless either stock finishes below its 75% barrier level, in which case investors will lose 1% for each 1% decline of the worst-performing stock from its initial level.

Two rather than one

“If this autocall was based on a single stock it would probably come with greater risk,” Hampson said.

“The reverse convertible-type of product on one name will give you a big headline coupon in a short period of time.

“But as we know, the downside risk can be substantial.”

Rather than choosing a more volatile single-underlying, another way to generate higher income is to pick more stable stocks and to tie the return of the notes to the lesser performing of the two, she explained.

“That’s what they did with this product,” she said.

“You have two less volatile, higher-correlated names put together to generate something close to double-digit return,” she said.

Volatility, correlation

The generous dividends paid by the two telecommunications companies (4.2% for Verizon and 6.65% for AT&T) contribute to their less volatile profile, she explained.

High-dividend stocks as they provide steady cash flow tend to trade more like bonds. As a result, their price fluctuations are more contained.

Comparing the volatility of the underlying stocks with that of the S&P 500 index at around 18.5%, she said that the product showed a relatively conservative profile.

“It’s not like buying an autocall on Apple or Amazon. You’re close to an index-type of worst-of even though these are still stocks.”

Another factor contributing to reduce risk is the fact that both stocks belong to the same sector. As a result, their performance is highly correlated.

In a worst-of, the less correlated the underliers are, the riskier the product. That is because investors are exposed to the risk of both stocks. If one declines, it will impact the overall performance no matter how well the other will perform, according to the risk section of the prospectus.

Product specific tests

Future Value Consultants offers stress testing on structured notes in order to assess the probabilities of occurrence of outcomes based on a given product type.

Each report contains a total of 29 sections or tests, which encompass simulation tables as well as back testing analysis.

To run her analysis, Hampson picked the midpoint of the coupon range at 9.37%.

She first looked at the product specific table, which showed the probabilities of barrier breach, call at the three “call points” and probabilities of coupon payment at those observation dates.

Living longer

The chances of an automatic call at point 1 in the neutral scenario was 43.37%, according to the table.

The neutral scenario is the basis of the simulation for all reports. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

“Autocalls on a single asset tend to have a 50% chance of calling at the first date,” she said based on her observations of other reports.

“The expectation to be called at point 1 will always be higher with one asset. To have both above initial level is a bit more difficult therefore your probabilities are going to fall.”

At 43% rather than 50% the probability exhibited in the table showed the impact of the worst-of in reducing the chances of an “immediate” call.

“Most investors want the call on the first observation date however so they can reinvest the proceeds elsewhere,” she noted.

“If you want more income, not kicking out immediately can be a good thing although it’s a riskier outcome since you just missed a chance to get your full principal back,” she said.

In the same line of thought, the probabilities of a call later on are higher than what the typical distribution would show for an autocallable linked to a single asset, she said.

“There are greater chances of calling at point 2 and 3 than normal, which makes sense because you’re still alive,” she said.

Investors always have to balance risk and opportunity, she added.

“It’s great to avoid kicking out at the first opportunity although in terms of risk most people prefer to get out,” she said.

The Monte-Carlo model also runs a set of four other market scenarios in addition to neutral. Based on volatility as well as different growth rate assumptions, those are bull, bear, less volatile and more volatile distributions.

In the bull market scenario, the probability of a call at point 1 rises to 48.22%.

“You get close to the single asset model here, which is normal since the market moving up increases the odds of both stocks moving higher,” she said.

Naturally the bear scenario produces the opposite result with a lower probability of 38.38%.

Getting paid

Similar to most contingent coupon autocallables, which show coupon barriers below initial price, the chances of getting paid are higher than the probabilities of an automatic call.

“It’s simply easier to be above the 75% level than the 100% level,” she said.

The product specific tests showed a 48.36% probability of receiving just one coupon, with the odds of getting more progressively declining.

“As it is always the case the chance of getting at least one coupon payment is the greatest,” she said.

Losing money

One easy way to assess market risk is to look at the chances of a barrier breach at maturity.

The final worst-performing stock will drop more than 25% at maturity only 15.81% of the time in the neutral scenario, according to the table.

“Given the fact that your return is linked to two underlying, it doesn’t look like a very high probability to me,” she said.

“The low barrier is rather effective in reducing the chances of losses.”

But there is a downside to having a protective barrier, she added.

“It’s a low barrier giving you a comfortable cushion if you don’t breach. But if you do, we already know that you will lose at least 25% of your capital, which is quite a big loss for one year,” she said.

Another table in the report called “investor scorecard” showed an average payoff in the event of a loss at 63.2%.

That would be an average loss of principal of 36.8% in the neutral scenario.

“This is significant. You have a low chance of losing money. But if you breach this barrier, your losses are huge,” she said.

“That’s why the coupon is quite attractive because the risk is there.”

HSBC Securities (USA) Inc. is the agent.

The notes (Cusip: 40435UEH3) will price on Jan. 25.

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